The European Monetary Union - Is it worthwhile to be a member?

3.0        Advantages of European Monetary Union

The single European currency was perceived to produce many advantages for the member states in the monetary union. These benefits are supported by a mixture of political, social and economic facets.

• Elimination of transactions costs/ Promoting Intra-EU Trade

Firstly, using the same currency would allow the reduction of transaction costs in dealings between the EU member states, that is, the direct elimination of exchange fees from doing business with each other. Transaction costs are usually incurred during the conversion of different currencies. These dealings not only involve the monetary cost considerations but also time and resources spent. Moreover the EU intended the removal of trade barriers between member countries, thereby eventually creating a single market. As a result of elimination of transaction costs (though not substantial in amount) and market segregation, businesses are prone to engage in intra-EU trade activities.

• More efficient allocation of Resources & Factors of Production

The single currency aimed at the removal of capital controls and discriminations between resource allocations among EU member states. Controls over capital movement in the past have caused the existence of sub-optimal allocation of resources. Hence the abolition of exchange-rate controls would consequently improve efficient capital allocation within the Union. Moreover, the same currency would allow better comparisons of wages and thus the movement of labour in an efficient way.

• Greater Price Transparency

EMU would reduce price differentials between the countries, making comparisons easier, and encourage competition whereby the ultimate gainers would be consumers benefitting in terms of lower prices. Moreover, reduction of price discriminations would allow an increase in market transparency.

• Efficiency and stability of Euro

To ensure stable currency exchange rates among all EU member states, the currencies of states that could not join EMU for not meeting the convergence criteria and currency of countries that chose not to be part of the EMU initially, were linked to the Euro, by the ERM2 (new currency exchange rate mechanism). In addition the Euro was seemingly a sound currency: the stability and growth Pact, the independent status of ECB (European Central Bank) and the ‘no-bail out’ clause of the Maastricht treaty being the most significant safeguards. Clearly, EMU was encouraging efficiency and stability and possibly a reduction of monetary risks by the pooling of risks. Therefore supporters of the EMU emphasize on economic growth likely to be generated by using Euro. As such, a likely reduction in unemployment rates of member countries participating in EMU.

• Savings in administration costs

Prior to the launch of the Euro, companies operating in different EU countries had to spend much in managing their exchange rate risks and uncertainties among businesses. Hence the monitoring of exchange rate fluctuations and hedging techniques used to be quite costly. The change to the single currency seemed to reduce the burden of such administrative costs of companies- the reason for most businessmen to be in favour of a single European currency.

4.0        Reasons why UK has not joined the EMU

There has been a lot of debate in the UK as to whether or not they should join the Euro, or continue with the use of the pound. For most people in the UK the decision will not be an easy one.

When the Maastricht Treaty was concluded in 1992, the UK opted-out from moving to the third stage of Economic and Monetary Union, meaning that it has not introduced the Euro yet. The opt-out clause was United Kingdom’s acceptance of the Treaty as a whole.

Moreover, as per the referendum held in 2003, the adoption of the Euro has been opposed. The reasons for not wanting to join include both economic and political factors.   Before the United Kingdom’s citizen’s vote in referendum on joining the EMU, Gordon Brown, the Chancellor of the Exchequer, announced 5 economic tests in his October 1997 statement that must be met before the UK joins the Euro zone. Each test assesses whether the British economy will benefit or suffer from the move. The five tests are as follows:

• Convergence of business cycles – This test involves that the business cycles in the Euro Zone and the UK to be compatible.

• Flexibility – This test revolves around the question whether there is flexibility in the system to ensure that asymmetrical shocks can be absorbed.

• Investment – This test emphasises whether UK's participation in EMU will promote investment in the long term

• Financial Services – This test focuses on the likely impact on the health of UK's financial services and competitive position by participating in EMU.

• Growth, Stability and Jobs – This test depicts whether EMU lead to positive effects on employment and growth, measured by the impact of foreign trade and macroeconomic stability.

Following the June 2003 assessment of the five economic tests, Prime Minister Tony Blair made it clear that the UK will adopt the Euro only when the economic conditions are deemed by the Treasury to be favourable to the UK.  It is clear the Treasury of the UK is not convinced that the five convergence criteria established in the Maastricht treaty is a satisfactory indicator for monetary union entrance. Thus, these tests are an addition to the formal criteria laid down in the treaty.  Hence, the convergence criteria, the five economic tests and the referendum form the very foundation of the debate of whether to adopt the Euro. The reasons why the UK has not joined the EMU rests on the following:

1. Past history and deflationary bias

Currency unions have shrunken in the past, thus no guarantee can be made to EMU being an achievement. Indeed, EMU is a step in a process that will segregate Europe from the rest of the world.  For joining the EMU, countries need to meet the Maastricht convergence criteria and in so doing, this tends to be deflationary for the UK.  Lessening UK’s public expenditure and/or increases in taxation will be required.  Consequently, purchasing power diminishes resulting in job losses and a fall in the living standards.  It has also been argued that by joining the EMU, UK will experience high unemployment.

2. The Euro not an Optimal Currency Area (OCA)

An Optimal Currency Area occurs when countries have achieved real convergence, when they respond similarly to external economic shocks or government policy, when they have adequate flexibility in both product markets and labour markets to deal with these shocks and high mobility of labour and wage flexibility.  However, European economies have not merged into a real structural sense and there is a panic that high interest rate will have to be levied in the future due to an inflationary fear in one part of the zone which may not be fitted to another.  Also within the Euro zone there is immobility of labour and insufficient wage flexibility for the members to cope during economic shocks.  There are also economic costs and risks resulting from losing the option to devalue the domestic currency in order to restore international competitiveness.  However, this might lead to emergent social dislocation and mounting economic inequality within the European Union.

3. Loss of domestic monetary policy freedom

Joining the single currency will lessen the UK’s monetary policy autonomy.  UK might wish to retain flexibility to impose short term interest rate so as to fulfil its internal macroeconomic goals.  However, once within the Euro zone, this will not be possible as domestic monetary sovereignty will be shifted to the European Central Bank (ECB).  There are fears that countries might dominate the operations of the ECB and impact on monetary policy within Europe if there are different inflation psychologies between member nations.

4. Business Cycle

According to the convergence of business cycle test, business cycle in the Euro zone and that of the UK must be compatible.  However, this is not the case as UK’s business cycle is closer to the United States rather than that of European member states.  The timing of economic business cycle is the key driver for the establishment of a monetary policy.   Figure 2 below displays the European Union's business cycle and figure 3 shows the United Kingdom's business cycle for the same time period.

         

                        Figure 2: European Business Cycle-Index

         

                        Figure 3: Business Cycle-United Kingdom

Source: (Figure 1 & 2) Incomplete Monetary Systems: Why the United Kingdom Has Not Joined the European Monetary Union by Michael J. Harrison, Pg 12-13 http://www.snhu.edu2835.asp

The figures above graphically portray how the United Kingdom's business cycle is not in sync with that of the European Union.  If the UK is not in sync with the other members of the European Union (EU), monetary policy activities carried out by the ECB may influence the business cycles of other EU countries positively whilst adversely affect the UK economy.  Furthermore, the single monetary policy will be disadvantageous for all as it may lead to high inflation to some countries whilst high unemployment for the rest.  Hence, there are doubts about the credibility and effectiveness of the ECB.

5. Monetary Policy asymmetry between the UK and the Euro zone

The UK economy is more sensitive to interest rate changes than other EU countries.  The reason behind this is the high scale of owner-occupation on variable-rate mortgages in the UK housing market.    Mortgages in the UK are different to those in the rest of the Europe.  In the UK, there is higher tendency for long term renting, and those that do have mortgages are on long term fixed rates.  Therefore, UK's homeowners are more likely to be affected by interest changes than their counterparts of other EU states.

By entering into a currency union with less monetary flexibility requires UK to be more flexible in its labour and product markets and housing market.  Additionally, Britain’s companies are heavily reliant upon debt finance to settle their investment projects rather than issuing new capital through capital markets.  This is another factor leading to monetary policy asymmetry and this is how UK firms are more faced to interest rates fluctuations than firms of the other EU countries.  Moreover, interest rates in the UK are higher because there has been greater growth of the UK economy in recent years, higher level of consumer spending was noted and the Bank of England wanted to slow down in house prices.

6. Adjustment Costs

The introduction of the Euro will require substantial changeover costs from joining the EMU.  Since there will be a single currency, that is, the Euro then costs of changing accounting systems, menu costs like vending machines, catalogues, postage, the costs of installing new payments will be incurred.  However, this will adversely affect the small-medium enterprises.  

There will also be loss of consumer welfare if suppliers charge high prices while converting Sterling into Euro.  Moreover, substantial fiscal transfer will be required for poorer countries within the EU along with European Regional Policy to lessen structural economic inequalities.  Nevertheless, the United Kingdom might not be able to afford such large-scale intra-European transfers.

7. Foreign Investment Issue

The UK is the biggest EU recipient of inward investment and strong reasons exist to believe that this would be negatively influenced if UK joins the EMU.  Joining the Euro may restrict the amount of long term borrowing the UK is able to carry out.  Euro Zone countries are subject to the Stability and Growth Pact, which means that countries must not spend beyond their means.  If the UK wishes to borrow money for long-term investment, this would be against the guidelines.

Moreover, the consequent increase in economic instability will diminish the attractiveness of the UK as a destination for capital flows.  Additionally, the UK's participation in EMU will impose greater non-wage labour costs of the EU on UK's business and hence the ability to attract investment will be weakened.  Overseas investors are not attracted by the UK’s convergence with EU but its divergence. Further integration would destroy the conditions which brought a disproportionate volume of overseas investment to UK.

8. The performance of the Bank of England

The Bank of England has been a factor undermining UK’s entry to EMU.  This is because the Bank of England has been able to sustain inflation within target and has kept the country in sustainable growth.  Moreover, UK has instituted within the Bank of England an efficient apparatus for managing interest rates.  The EMU will remove this policy lever along with withdrawing the opposite exchange rate policy.

9. International Position

The city of London has been amongst the three world financial centres along with New York and Tokyo.  Integration in the EMU threatens UK’s international position which is more pivotal than its European role.  If EMU leads the fiscal and political union, the UK’s role in global markets will be jeopardised.  Hence, if UK is put through a more regulative administration, its role as an international financial centre will diminish to the benefits of New York and Tokyo.  However, by operating outside the single currency, UK will dominate Euro trading as it dominates US dollar and Deutsch mark trading nowadays.

5.0        Reasons why Denmark has not joined the EMU

11 member states of the European Union (except UK, Denmark, Sweden and Greece) locked their currencies together irrevocably from 1 January 1999.  The Maastricht Treaty concluded in 1992, providing Denmark with an exemption clause or “opt-out” under which the country did not have to enter the third stage of EMU or thereof involving a single currency- the euro. Denmark was generally recognised to be one of the ‘prein’ countries, that is, countries simply waiting to join the EMU. However, as it turned out, such is not the case.

As UK, Denmark negotiated special terms under the Treaty which allowed it to postpone the decision whether or not to join the single currency. Following intense negotiation between the EC and the Danish government, a legally binding compromise was agreed by the heads of state and government at the European Council in Edinburgh (under the UK EC Presidency), whereby Denmark would not enter the third stage of EMU without securing approval in a referendum. The agreement, known as the Edinburgh Agreement, was adopted as a ‘Decision’ of the Heads of State and Government and later annexed to the Treaty.

The protocol provided that the automatic progress towards the 3rd stage of EMU which was applicable to the other member states would not apply to Denmark if the Danish government gave a notification of so before the compliance with the convergence criteria were assessed. Clearly, there was an incompatibility between the Danish Constitution to the advance commitment of automatic application of the EMU. The constitution required a referendum to be held to authorize the ‘transfer of powers to supranational authorities.’

Denmark emerged from two referenda (June 2, 1992 and May 18, 1993) on the Maastricht Treaty on the European Union with four exemptions: common defense, common currency, EU citizenship, and certain aspects of legal cooperation, including law enforcement. In the referendum on 2 June 1992, the Danes voted by 50.7% to 49.3% against a Bill to approve the Treaty on European Union (or Maastricht Treaty). The Bill had been approved in the Danish Parliament, the Folketing, by 130 votes to 25 with 20 abstentions, but this did not achieve the required five-sixths majority needed to approve the delegation of national powers to international authorities without a referendum.

The difference between the two camps was 46,269 votes. Although this was not an altogether surprising result, it presented both the Danish government and the rest of the European Community with a dilemma regarding the future of the Treaty that had been signed by all twelve Member States on 7 May 1992.  Denmark comfortably meets the economic criteria for EMU and its economy tends to move in cycle with the rest of the euro zone, so it could accept interest rates set by the European Central Bank (ECB) without difficulty. But the government was cautious about early entry because the electorates were highly sceptical about this.

Since the Treaty had to be ratified by all members (requiring a consent of the Treaty), the Danish Government negotiated on a series of side agreements or ‘opt-outs’ in Edindurg stating, (1) Denmark will not participate in the single currency (2) rules binding upon members of the EMU would not be binding upon Denmark (3) It will retain monetary powers (4) will participate in EMS, and others. The referendum following the agreements on 18 May 1993 was approved by the Danish electorate. However, in 2000, after the adoption of the single currency- Euro by other member states, a referendum held specifically on the 3rd stage of EMU was again rejected by 53.1 %. The Danish refusal to participate in the EMU is constitutional, based on political rather than economic grounds.

Several reasons accounted for the refusal to the single-currency by the Danish people. The ‘No’ campaign focused on populist and emotive issues such as:

• Loss of sovereignty. 33% of the electorate rejected the 3rd stage of the EMU for fear of losing sovereignty, that is, the Danish identity. Denmark has a long history of defending its sovereignty against more powerful neighbouring countries. The fear of facing such circumstances by adopting the single-currency has contributed in the rejection.

• The perceived move towards a federal Europe

• Increased immigration from less prosperous EU Member States

• The weakness and volatility of the euro, compared with the strength of the krone.

• Campaigners have argued that participation will endanger the welfare state and could lead to tax harmonisation which could undermine pension and unemployment entitlements.

• The DPP also suggested that the euro would be a threat to the Danish monarchy.

• Another argument was that the European Central Bank can only have one interest rate which will always be to the benefit of the central economies. How can the bankers in Frankfurt get a uniform interest rate of 4% to work like 2% in Germany or 6% in Ireland, if the demands are so distributed?

The Danish government had refused to calculate the costs of changing all computer software, machinery, price lists and slot machines. The strategy of the government and months of hard work was killed overnight by an independent report from the Danish Wise Men. They produced a very balanced report and concluded it by saying: "Summing up, the Chairmanship assesses the purely economic costs and benefits for Denmark of EMU membership as being small and uncertain."

Interviews with most of the Danish economics professors in the papers showed the same conclusion. Most economists would vote for EMU - but for political and not for economic reasons.  British Euro-opponents set up a trust called the Danish Referendum Campaign to help their Danish allies in the ‘no’ campaign. The British appeal aimed to raise £50,000 to pay for advertisements in the Danish press in the run-up to the referendum.

The appeal was also sponsored by the Bruges Group and the Anti-Common Market League. British Conservative MEP, Daniel Hannan, addressed the annual congress of the Danish People’s Party in September, although not all Danish anti-euro campaigners welcomed the UK support, some warning that it might drive voters to the pro-euro camp.  Anti-euro lobby gained support from younger voters, the elderly, women, high wage-earners, farmers, fishermen and monarchists from rural Jutland.

The majority of Danes, if perhaps ambivalent about Europe, are not anti-European and favour closer cooperation in many areas of EU activity. Referendums on EU matters and Treaty reforms have generally been close, with the exception of the 1972 referendum on EEC entry, in which there was a clear majority for membership, and the vote on the euro on 28 September.

There has been a reluctance to trust either the government or the opposition, or the leaders of any of the pro-euro parties.  These concerns were at the forefront of the September 28, 2000 referendum on Denmark's participation in the third phase of the Economic and Monetary Union, particularly the common currency, the euro; more than 53% voted "no," and Denmark retained its "krone" currency unit.

The government and the pro-EU opposition have agreed, and Denmark has received an EU green light, to maintain the four opt-outs throughout the process of approving and ratifying a new EU constitutional treaty, with the ambition to eliminate all opt-outs in the longer term.  The government intended to put Danish approval of the new EU constitution to the public in a referendum, but that process has been put on hold until further discussion of the constitution has taken place in the European Council.

Denmark's chances of influencing the future development of the EU are good. Denmark has much to offer and has demonstrated its ability to make use of the possibilities for influence in the past.  At the same time, Danish EU policy is characterised by special constraints. These constraints are not least due to the Danish opt-outs. Denmark loses influence on questions which also affect Danish interests.

This is obviously the case in the three areas which are covered by the opt-outs that is the common currency (the euro), European Security and Defence Policies and Justice and Home Affairs. In these areas Denmark is experiencing a real and tangible loss of influence.  It is also the case in a more general sense. The opt-outs may contribute to an image of Denmark as a Member State which does not participate whole-heartedly in the EU. This has an influence on the general position of Denmark and may reduce Danish influence on the overall development of the EU.  This underlines how important it is that Denmark makes use of the possibilities that exist and actively promotes Danish interests and points of view in those areas which are not covered by the opt-outs and where Danish influence therefore is bigger.

6.0        Future Prospects

6.1 Will UK and Denmark join the EMU?

The rate at which the UK might join the Euro is important because this would determine relative prices.   If the UK joined at too high a rate, it would mean that exporters would find that their prices had effectively risen making them less competitive whilst imports would appear cheaper.  The disruption to UK's competitive position could have long-term effects as businesses would have to find ways of regaining the competitiveness that they had lost.  

This could be difficult especially in the case of manufacturing industry when margins might be already very tight and there is not much room for improving efficiency and productivity.  If UK joined at too low a rate, the opposite position would arise; imports would become expensive, thus increasing business costs but exporters would see some benefits in terms of improved prices.

Having analysed the pros and cons of the Euro debate, one tends to have one’s own views of whether UK should join the Euro. In fact, the idea of UK joining the single currency is shared unanimously by all Europhiles. Amongst others, European Trade Commissioner, Peter Mandelson argued that UK’s case for staying out of Europe’s single currency is becoming weaker. Hence, it is tempting to conclude that UK should scrap the pound in favour of the Euro.

However, joining the euro is not riskless. Indeed, there are numerous risks and potential drawbacks as identified in our discussion. By standing aside, UK will avoid the instabilities that the single currency will cause and it will also keep its present competitive edge. Moreover, the reasons for not adopting the single currency are mostly of an economic nature, but the political issues have proved to be persuasive as well. The two key political persons in the debate are (at that time) the Prime Minister, Tony Blair and Chancellor of the Exchequer, Gordon Brown, Britain’s Finance minister.  Thus, with the present world economic outlook, one thing is for sure - the UK’s prospect of joining the euro at present seems very bleak! However, we should not eliminate the possibility of an eventual entrance of the UK in the EMU in the near future.

Denmark Today

It has been found that it is more for political reasons (rather than economic ones) that the EU-3 (UK, Denmark and Sweden) have not yet introduced the euro. Though the governments are in favour of the single currency, public support through referendum is doubtful. The EU-3 is mostly concerned with their loss of identity and loss of decision making power over monetary issues.  Denmark is not in the monetary union but the Danish krone has however remained within the EMS and been part of the new exchange rate mechanism (ERM II). The krone was previously linked to the Deutschmark and since 1st January 1999, to the Euro. It fluctuates within a band of 2.25 % on either side of the euro. The country meets and in fact exceeds all the convergence criteria to be in the EMU. Yet, the Danish people voted against and are as yet excluded from the EMU. However, we can find on the government website now () in October 2007, that opinion polls reflect support of the Danish towards inclusion in the EMU, vote that exceeds 60 % in favour of the single-currency, that is, the Euro.  

6.2 The future of Single Currency

The consequences of a single currency: Perspectives for the future

• The most important effects of the single currency relate to the possibility of improving macroeconomic stability and credibility for the policies pursued; these effects are particularly important for the smaller European countries.
• Monetary Union will make it possible for the participating countries to combine their credibility. In this way, small countries can, to a large extent, “borrow” credibility from some of the large countries which have pursued stability-oriented policies for a long time.
• One very important consequence is that the use of a single currency will give rise to larger and more competitive financial markets in the euro area.
• The markets for private bonds are still segmented owing to the differing institutional and regulatory conditions across member states, but they too, will gradually integrate and provide an incentive for increasing the issuance volumes of private bonds. This will contribute to reducing the financing costs for private companies, and it will provide improved opportunities for investors.

7.0        Conclusion

We believe that the conversion to a single European currency provides numerous advantages. The utilisation of the common Euro eliminates the currency exchange fees from the cost of doing business between the European states. Companies will be more apt to compare prices with their competitors, which may promote competition and may result in lower prices for consumers. By encouraging stability and efficiency, proponents of the EMU hope that the use of the Euro will stimulate economic growth and may reduce the unemployment rates in the participating member states. International investors will likely diversify their portfolios with Euros, encouraging more investment in the European continent.  Countries like Romania and Bulgaria have joined the EU in January 2007.  These countries are likely to join the EMU, following a procedure which is expected to be similar to the one which applied to the first group of countries which adopted the Euro. The EMU thus seems a success but it depends on the UK’s government whether to join this successful venture while for the Denmark, its integration with the EMU is on the way.

8.0        References

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