SHOULD THE UK JOIN EMU?

Introduction

Many on the continent relish the opportunity of pooling the power of Europe in order to stand up to the US who has for so long used its weight to secure its position as the only superpower.  Some in Europe fear that left as individual nations, Germany would emerge by far the strongest in Europe and would eventually dominate the continent.  These feelings are behind the creation of the EU and the Euro.

This report is split into 4 chapters.  The first chapter deals with the supposed benefits of a single currency in Europe.  Chapter two is a critical analysis of Robert Mundell’s theory of Optimum Currency Areas.  This is the most widely accepted theory on how to test the viability of a currency area.  In chapter 3 we take a closer look at the UK, specifically the five tests that Gordon Brown ‘insists’ must be met before the UK can join EMU.  Finally we take a look at some other factors that may affect whether or not the UK should join EMU.

CHAPTER 1

The Benefits of EMU

According to the European Commission there are four main benefits of a single currency.

1: Cost savings on cross-border transactions

2: Increased price transparency, which benefits the consumer.

3: More stable prices due to the anti-inflationary ECB

4: Elimination of exchange rate instability and uncertainty within EMU

1 is only really significant for Northern Ireland business, which makes up a very small part of GDP.  The savings from transaction costs for the rest of the UK are so low that they are offset by the cost of changeover for the first 30 years (Minford 2002).

2 only really applies to large purchases of goods such as cars, especially now that most of the EU has joined the Euro making it very easy for British consumers to compare prices.  Increased technology and the Internet makes it very easy for UK consumers to calculate Euro values.

3: During the last 10 years Britain has had stable prices, especially since the B of E has taken control of interest rates.  There is more chance of volatile inflation under a larger currency union.

4 helps Britain’s trade with the EU.  It also makes the price mechanism a more reliable tool for making investment decisions as the adjustment process of exchange rates is no longer necessary.

However, because the Euro is more volatile against the Dollar, it hinders our trade with the rest of the world, unless the Euro can equal the Dollar as a world currency.

‘A doubling of Dollar risk for the elimination of Euro risk would be welfare reducing, even though average risk would be unchanged.  The reason is one of diminishing marginal utility.  The gains of the Euro trader get progressively smaller as the risk falls to zero, but the losses of the Dollar trader get progressively larger as risk rises to doubling’ (Minford 2002 p.29).

Risk Sharing

Mundell points out the advantage of risk sharing that comes with monetary union.

A harvest failure, strikes, or war, in one of the countries causes a loss of real income, but the use of a common currency (or foreign exchange reserves) allows the country to run down its currency holdings and cushion the impact of the loss, drawing on the resources of the other country until the cost of the adjustment has been efficiently spread over the future. If, on the other hand, the two countries use separate monies with flexible exchange rates, the whole loss has to be borne alone; the common currency cannot serve as a shock absorber for the nation as a whole except insofar as the dumping of inconvertible currencies on foreign markets attracts a speculative capital inflow in favour of the depreciating currency.’ (Mundell, 1973, p.115)

Through risk sharing there would be lower interest rates.  For any given interest rate that is higher, investment projects will tend to be riskier in order to justify the high rate of interest.  This in turn pushes interest rates up.  By sharing this risk across a currency union, lower interest rates reduce the amount of risky projects that are selected by the market.

De Grauwe argues that a lower interest rate and the expectation of lower interest rates will encourage growth in the short term.

FIGURE 1

When uncertainty decreases, R1 moves to R2 and the economy will temporarily grow faster until it reaches point B, at which point it will return to the Long-term growth rate.

The Euro as a World Currency

From the outset the ECB has been very anti-inflationary.  This has safeguarded the value of the Euro on international markets.  The future looks good for the Euro as a world currency.  The recent falls in the value of the dollar may lead many speculators to switch to the Euro as a more reliable store of value.  If Britain were part of EMU this could mean investing in Britain.

Currently many in Europe are worried by the value of the Euro against the dollar.  This is primarily because world trade is largely conducted in dollars.  If that were to change to Euros, Britain would gain from being a part of EMU.

Negotiating as the EU, the individual countries of Europe have been able to stand up to the USA on trade issues.  EMU could work in the same way to protect our interests.  In the past, the countries of Europe have at times been forced to prop up the dollar in order to protect their export markets, not only to the United States but also to the rest of the world, as the dollar was the currency of choice for most international dealings.

‘In 1987 two thirds of the US current account deficit was financed not by the private markets but by foreign central banks who were afraid of the competitive effects of their currencies appreciating against the dollar’ (Transatlantic Perspectives on the Euro, p.24)

With the euro, Europe no longer has to concern itself as much with the value of the dollar.  Obviously trade with the USA will be affected by a weak dollar, as is the case today.  However, that accounts for less than 15% of trade for most EU countries.  If the euro maintains its strength and reputation it could lead to many advantages.

Europe will gain in terms of seigniorage.  Seigniorage is the revenue that a government receives from the use of their currency.

‘If the Euro were to close one half of the gap between it and the dollar as a currency of denomination of private international financial assets, roughly $400 billion in investments would be re-allocated from dollar to Euro assets’ (Transatlantic Perspectives on the Euro, p.24).

However, the European capital markets may take longer to take full advantage of the single currency.

‘Stock market capitalisation of the euro – 12 countries was roughly 1/3 of the US in 1995.  Adding the UK would raise it to ½.’ (Transatlantic Perspectives on the Euro, p.25)

Even without stock market capitalisation, if the Euro is a strong currency, foreign investors will wish to invest in Euros in some way or another.  European banks will attract investment.  The size of this effect, however, is uncertain.  London is the financial centre of the world without having a major domestic currency.  But the Euro could provide a useful boost to Foreign Direct Investment.

EMU will increase our levels of international trade

Increasing trade is one of the primary objectives of the EU.  Trade increases output through increased specialisation and a more efficient allocation of resources.  Trade increases our consumption possibilities.  All countries gain regardless of income level or economic structure.  As long as they are different in technology (Ricardian model) or in factor endowments (Heckscher-Ohlin model), potential gains from trade always exist.  Therefore if a common currency induces large increases in trade it is an important benefit of EMU.

Rose (2000) considered the effect that a common currency area has on trade. He was the first to do so.  He explains that there are potentially massive gains from a currency union.  He uses the gravity model to calculate the effects.  Rose makes a valid point that trade within a domestic economy far exceeds that of trade across international borders, and that the more we move towards making the EU a domestic market, the more trade across the European borders will increase significantly.

‘The evidence of international bias is clear; trade within countries is simply huge compared to trade between countries, even for well-integrated areas like the EU.  Countries have a number of important aspects for commercial trade, including a common currency, common cultural norms, common legal system, common history, common norms, and so forth.  A common currency is a piece of this package; and it seems to be an important piece’ (Rose 2000 p.32).

‘Countries that use the same currency tend to trade disproportionately.  My point estimate is that countries with the same currency trade over 3 times as much with each other as countries with different currencies’ (Rose 2000 p.17).

Rose uses the example of trade across Canada and with the US to illustrate this point.

‘Trade between two Canadian provinces is more than 20 times larger than trade between a comparable Canadian province/American state pair.  Part of this home bias effect may stem from the fact that a single currency is used inside a country’

(Rose 2000 p.11)

He explains that the benefits of a currency union have previously been underestimated because people have assumed that the effects of a fixed exchange rate would be the same as the effects of a currency union.  Rose finds that there is a big difference.

‘Most of the extant literature presumes that a common currency is equivalent to reducing exchange rate volatility to zero (Frankel and Rose).  Yet my estimates easily distinguish a currency union and zero exchange rate volatility…The effect of a common currency is much larger than the hypothetical effect of reducing exchange rate volatility to zero’ (Rose 200 p.17).

The seemingly small costs of exchanging currencies seem to deter people quite a lot.  Johnny Akerholm uses Rose’s discussion to point out that trade is typically based on long-term relationships.

‘If a firm wants to penetrate a foreign market, investment in trade channels and marketing is required over several years.  A common currency reduces the risk and enhances the market, in particular for small and medium sized firms’ (Rose 2000 p.39)

Conclusion

To conclude, there are many benefits associated with EMU.  The principle benefit is the free flow of trade, which has been quantified by Rose and appears to have massive potential for growth.  Many of the gains we haven’t mentioned are political rather than economic.  Therefore even if the gains don’t prove to be that large, as long as the costs don’t outweigh the benefits, Britain should join EMU.  In the next chapter we look at the Theory of Optimum Currency Areas and analyse the potential pit falls of a Monetary Union.

CHAPTER 2

The Theory of Optimum Currency Areas and how it applies to the Euro

The Theory of Optimum Currency Areas provides a useful framework from which to examine the costs and benefits of creating the euro.  From this framework I shall apply the points to the UK.  The theory was first developed in 1961 by Robert Mundell and then later revised by Ronald McKinnon.  Mundell is sometimes known as the ‘father of the euro’ because in 1970 he wrote two papers supporting the idea.  However, opponents to the euro often use his first theory to support their arguments.  Mundell 1961 was in favour of making currency areas smaller, not larger.

Mundell 1971 ‘presented a different—and surprisingly modern—analytical perspective. If a common money can be managed so that it’s general purchasing power remains stable, then the larger the currency area—even one encompassing diverse regions or nations subject to “asymmetric shocks”—the better’ (McKinnon 2000).

When people refer to the theory of Optimum Currency Areas (OCA) they generally refer to the original model of 1961.  In this chapter I shall look at OCA and try to establish if the UK is part of an optimum currency area with the rest of the EU.

There are 4 conditions for an Optimum Currency Area (Barrel and Dury 2000).  Symmetric shocks, fiscal redistribution, a mobile labour force and flexible wages.  In this chapter we shall examine how well the EU fits these criteria.

Higher Interest Rates Outside of a Monetary Union

Today, Latin American countries on the periphery of the world dollar standard have much higher interest rates than those in the United States; and before the advent of the euro, the weak currency countries of Italy, Spain, and so on, operated with higher interest rates and shorter-term finance than in Germany. The gains from proper risk sharing through a common currency should show up as a net reduction in risk premia in interest rates for the system as a whole.(McKinnon, 2000, p.5)

It is becoming increasingly clear that the Latin countries of Europe such as Spain Italy and Greece have a lot to gain from the financial stability that the euro brings.  However, it is not clear that Britain would gain in the same way.  This is because the Bank of England has stabilised inflation and the exchange rate in this country.  Nevertheless, the BOE base rate currently sits at 4% while the ECB is at 2% and the industrialised world average is 2.5%.  Would British business not gain from rates being almost 2% lower?  How would the city suffer or gain from lower interest rates?  We answer these questions later on.

TABLE 1

                                                                                                                                                                                                                                                                                                                                                                                                                                               

The essential point of OCA with regards to the EU is that if an asymmetric shock were to hit two parts of the EU, there would be unemployment in one region and inflation in the other.  The main reason is that the instrument of monetary policy has been lost, and the other mechanisms that regain equilibrium are not flexible enough in modern Europe.

What are the effects of Asymmetric Shocks?

Here is a hypothetical example of the effects of an asymmetric shock on demand if Britain and Germany were in a currency union together.  Assume that for some reason consumers shift their demand from British goods to German made goods.  Britain would experience a demand shift to the left and Germany to the right.

FIGURE 2

                                Britain                                                Germany

The result of the shift is an increase in German output and a decrease in British output.  If spending by British residents does not decline by the same amount, Britain will have a current account deficit, Germany will have a surplus, Britain will experience unemployment and Germany will experience higher inflation.

However, there are two mechanisms that will bring back equilibrium without exchange rate intervention.

Wage Flexibility

If the British and Germans had flexible wages and complete price transparency, the following would happen.  Unemployment in Britain would push wages down; German demand for labour pushes wages up.  British products become more competitive, stimulating demand.  The opposite occurs in Germany and equilibrium is restored.

Mobility of Labour

Even if there were little wage flexibility, perfectly mobile labour would negate the need for British wages to come down.  Current Account disequilibrium is solved by the elimination of the imports of the otherwise unemployed British who move to Germany.  However, due to language and cultural barriers, labour mobility in the EU is not common.

Otherwise

If either of the conditions is not satisfied, the problem will not disappear.  Instead, the excess demand for labour in Germany will increase wages there, causing inflation, which in turn makes British products more competitive.  Germany can resist inflation through monetary/fiscal policy, in which case the current account surplus will not disappear.  Eliminating the surplus would mean accepting higher inflation.  Britain would have to accept a current account deficit and unemployment.  We examine the institutional differences of labour markets in a later chapter.

How likely is a Demand Shock?

In the report ‘One market, one money’ the European Commission says that monetary union reduces the chance of an asymmetric shock.  Trade becomes much more integrated.  So, for example, if consumers reduce their demand for cars, they will reduce demand for cars from all countries, not just one.  Most demand shocks will be symmetric.

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However, trade integration also leads to regional concentration.  For example finance in London or car production in Germany.  Therefore, a demand shock that is sector specific could become country specific.

On the other hand, there is no reason why these regional concentrations would not transgress borders.  Therefore, national economic measures are less effective.  Furthermore, there is still the option of fiscal measures, which can be directed towards specific industries.  Foreign exchange intervention and interest rate policies will become less relevant if industry clusters cross borders.  Frankel and Rose (1998) have found empirical evidence that supports the view of ...

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