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Critically examine the Economic Consequences on Britain of adopting the Euro?

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Samantha Bentham                                                                                                      Britain’s Economic Performance.

Critically examine the Economic Consequences on Britain of adopting the Euro?

  Before looking at the economic consequences of adopting the Euro we first need to know why some countries decided to move to a single currency and how the use of the Euro as that single currency came about.

  The process enabling the introduction of a single currency, the Economic and Monetary Union (E.M.U.) was developed in three stages. Stage 1 was from July 1990 to December 1993. This stage involved the removal of internal barriers to free movement of capital throughout the EU.

  Stage 2 which began in January 1994 introduced the European Monetary Institute, which is now known as the European Central Bank (E.C.B.), to reinforced monetary policy co-ordination and prepared for the launch of the European System of Central Banks. (E.S.C.B.)

  The final stage started in January 1999 with the permanent fixing of exchange rates of the old currencies to the Euro. This meant that monetary policy was transferred to the European Central Bank. On January 1st 2002 the use of Euro notes and coins came into operation in the 12 countries who had signed up to become full members. These member countries are known as the Eurozone. The Eurozone consists of Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain.

 Although these stages started in the 1990’s the development of a European single currency dates back to the 1950’s.

  In 1957 the Treaty of Rome stated that a common market across Europe could increase economic resources and would help to promote closer ties amongst the people of Europe and as early as 1969 a European summit at The Hague makes the issue of a single currency across Europe an official objective. In 1970 the Werner Report proposed the three stage process described earlier but expected it to be completed by 1980.

“the ultimate creation of a European federal state, with a single currency. All the basic instruments of national economic management (fiscal, monetary, incomes and regional policies) would ultimately be handed over to the central federal authorities. The Werner report suggests that this radical transformation of present Communities should be accomplished within a decade”. Con O’Neill (1970)

  The problem was that the world economic crisis of the 1970’s put the schedule off balance and meant that the development of the Euro was deferred until the 1990’s.

   In 1979 the European Monetary System was created. This had an exchange rate mechanism (E.R.M.) which defined rates in relation to the European Currency Unit (E.C.U.). The E.C.U. was a currency that represented an average of the currencies from the participating countries. In 1988 the European Council of Hanover set up a commission to put forward plans that would lead to European Monetary Union. This was chaired by Jacques Delors, who was the president of the European Commission at this time,

Finally in 1989 the European Council after considering the Delors report agreed to commence on the first of the three stages of E.M.U.

In order to create an economic and monetary union the single market would have to be complemented with action in three interrelated areas.’ The Delors Report (1988).

  There are many advantages to joining a single currency, although just how beneficial these advantages are is questionable.

   The most obvious benefit of a single currency would be transactional cost savings. Money is always lost when currencies are exchanged therefore a single currency would mean that the currency exchange between pounds and euros would no longer exist. This would also mean there would be savings from the removal of charges on traveller’s cheques and credit cards.

  Some critics of this argument have stated that the savings which occur from the elimination of these charges would be offset with the loss of profits to the banks which administer these services but this line of reasoning would be incorrect as the transactional costs of exchanging money is viewed as a ‘deadweight loss.’ ‘Applied Economics’ Atkinson B. et al.

In 1990 the European Commission carried out a study of the savings gained due to the eradication of transactional charges and found that on average there would be a saving of 0.4% of G.D.P. However for countries such as the U.K. with advanced banking systems the savings were found to be much smaller, around 0.1% of G.D.P which translates as approx. £1 billion per year which is a moderately small sum. This is because a considerable amount of currency exchanges between pounds and euros occurs through the banking system.

  Although this is in principle a gain that would continue indefinitely it seems likely that these gains would be progressively reduce in magnitude as credit cards and other payment mechanisms are used. A more reasonable conjecture may be that the gain would remain at a constant of approx £1 billion in today’s prices.

 There is also the large one-off transactional cost of converting from the pound to the Euro. This includes changing over A.T.M.s, vending machines and accounting systems. There has been a series of estimates for these costs which was reviewed by the House of Commons Trade and Industry Committee in 2000. Their findings stated

‘that a reasonable central estimate of the changeover cost was £30 billion.’ Patrick Minford. (2002)

Another benefit of monetary union would be the elimination of exchange rate variability.Uncertainty can be caused by the fluctuation of exchange rates and having no knowledge about future prices leads to decision making becoming harder. A firm investing in another country has a greater uncertainty about what returns it will receive that if they invest in their own country.

  However opponents of the Euro dispute this fact. Bainbridge et al (1996) argues

‘traders can use forward exchange markets to reduce or eliminate these risks’ and that empirical research ‘has not found any robust relationship between exchange rate variability and trade.’ Applied Economics’ Atkinson B. et al ( pg 440.)

One argument put forward by supporters of a single currency is that monetary union would eventually lead to lower interest rates. The reason given for this is that before the introduction of the Euro the majority of countries in the E.U. had to keep their interest rates above Germany’s to stop an outflow of investment into Germany to benefit from their stable currency. With monetary union the Euro became a stable and therefore interest rates dropped to the German level. Johnson (1996) claims that:

‘ Real interest rates would fall by 1% leading to more investment, cheaper mortgages and lower prices.’

He also claims that:

‘it would raise the potential growth rate of the U.K. economy from 2.5% to 2.75% or even 3%.’  Applied Economics’ Atkinson B. et al (pg 440.)

If this is true the government would benefit due to the interest paid on it borrowings would fall and it would also go some way towards reducing unemployment levels.

  Supporters of a single currency also believe that it would encourage a lower inflation rate. Inflation in the U.K. has always been continuously higher than the ‘core’ E.U. countries. They believe using a single currency will guarantee lower inflation rates and the U.K. will benefit from the resentment of higher prices across Europe.

Patrick Minford refutes this point, he states:

‘All inflation can be conquered without E.M.U.; all that is required is appropriate national economic policies, notably control of the money supply.’ Patrick Minford (1995).

  Another advantage of a single currency is that competitive devaluation will be eradicated. Devaluation is a reduction in the value of one currency against other currencies. It usually implies an official lowering of the value of a country’s currency. In the years between the two world wars several countries became involved in the practise of competitive devaluation (when a country matched the devaluation of other countries). Although this practise has been discouraged since WWII there is always the risk that it may reoccur. With the growth in intra-National trade any return to competitive devaluation would have catastrophic results on the economies of Europe. The potential threat of these economic disturbances is eradicated by the use of a single currency.

  Opposition to a single currency view the removal of competitive devaluation as detrimental to the economy. When a country becomes less competitive than another one way to rectify this problem is to devalue its currency. This in effect will lower the prices of that country’s exports therefore making their goods more attractively priced, whilst at the same time import prices will rise. A single currency would effectively stop this from happening and another way will have to be found to cover this adjustment. One option would be to cut real-wages. However it is impossible to do this without causing a decline in income and a rise in unemployment levels. This also quite often leads to a spiral of falling income which leads to decline in investment which in turn leads to a drop in employment levels and so on.

  Many economists do not agree with this argument. Devaluation only leads to a short-term respite from the economic problems of uncompetitiveness. In a short period of time the rising prices of imports would lead to higher inflation and eradicate the price advantage gained by devaluation.

There are also distinct disadvantages to joining a single currency. One of these would be loss of sovereignty and this is both a political and economical argument. Firstly the politicalaspect is best described by the following statement.

‘The major argument against a single European currency is that it would be a major step on the way to a single European nation.’ Redwood (1995).

Redwood argued that many of the current policies imposed by the E.U. already cause contention between member states and the addition of more legislation would only amplify tensions. Furthermore economic policy would be decided within Europe and this would lead to a democratic deficit because there would be little or no reason for debate between U.K. politicians.

On an economical basis there is the argument that what is beneficial for the E.U. as a whole may not be favourable to individual member states.

‘The main disadvantage of a single monetary policy is that the larger, more varied and disparate the union, the less likely it is that the monetary policy will be appropriate for all parts of the union at all times. Lord Nigel Lawson - former Chancellor of the Exchequer (1996)

Consequently the European Central Bank may approve a policy that benefits Europe as a whole but is detrimental to the U.K. economy. This is quite a probable situation because the U.K. economy differs immensely from other European economies. Whilst most European countries rely heavily on agricultural economies the U.K. has an extensive oil industry and its economy is based more in the service industry, in particular financial services, therefore it is very unlikely that a policy appropriate for Europe as a whole would be suitable for the U.K.

  There are both beneficial and detrimental economic consequences to joining a single currency to any member states and some which are particular to the British economy.

  One of arguments for the U.K. to participate in a single currency is that many foreign firms invest in the U.K. One of the reasons for this is that two of the largest economies in the world, the U.S.A. and Japan are predominantly English-speaking countries and this means communication between countries is easier. Another more economical reason for foreign investment is that labour costs are lower in the U.K. than most countries in the E.U. consequently many foreign firms locate here but by not joining the E.M.U. these foreign firms are left open to exchange rate risks. Therefore foreign firms are likely to choose other countries for their investments.

Contrary to this recent figures show that this in not the case. Investment in Britain nearly quadrupled in 2004 as £44 billion of foreign investment poured in and Britain benefited from strong economic growth. This put the U.K. just behind the U.S.A. for inflow of investment. Whereas Germany and Italy both suffered due to their weak economic growth and stiff labour markets and France had to actively promote investment from foreign businesses despite using a single currency.

  Some economists view a single currency asunnecessary for the U.K. because our currency, £ sterling, is already a major currency in world trade and is amongst the highest valued of all base currency units in the world. Sterling is used as a reserve currency worldwide and is ranked third. This is probably down to the stability of the British economy and government in conjunction with high interest rates compared with other major currencies.

‘Buoyed by the highest interest rates in five years, the pound was poised for its biggest annual gain since 1990 thanks to its new status as the world's third-most popular reserve currency, after the dollar and the euro.’ Pan A. International Herald Tribune (28/12/06)

Since the Euro was introduced although it is not fixed to the pound it usually moves in alignment with it, that is until the middle of 2006 when this relationship weakened. Concerns about inflation led to the Bank of England raising its interest rates this meant that sterling rose to highest rate against the Euro since 2003.  This had an effect on the pound against other major currencies in particular the U.S. dollar which on November 7th 2007 reached $2.10, its highest exchange rate in 26 years.

  After looking at the advantages and disadvantages of joining the Euro we need to look at why Britain has not joined the single currency. In 1997 the previous Chancellor of the Exchequer, Gordon Brown, specified five economic tests that he stated must be met ‘clearly and unambiguously’ met before making the important decision as to whether or not Britain should replace the pound with the Euro.

It is vital the decision – one of the most momentous ever taken – is made in the British National economic interest.Gordon Brown (1997)

The first of these tests is Convergence. This test looksconsiders the economic structures of Britain and decides whether they would be compatible with Euro interest rates on a permanent basis and would a single interest rate be suitable for all member states using the Euro over a sustained period of time. It also looks at how an economic disturbance would affect each Member’s economy and how an economic problem in one member state would affect other members of the single currency. If it could happen that a problem in another country could directly influence Britain’s economy then the government would not consider there to be enough convergence for the UK to join the Euro.

  The second test is Flexibility. This test looks at the capability to react effectively and promptly to any economic change to ensure that economic disturbances do not have any long-term consequences.

  The third test looks at Investment. Would joining the Euro generate more beneficial conditions for firms wishing to invest in Britain in the long term?

  The fourth test examines the effect on the competitive position of the financial services industry, in particular the wholesale markets of the City of London, of joining the Euro.

  The fifth test looks at whether or not joining the Euro would encourage growth, stability and employment.

  In 2003 the Chancellor stated that only one of the five criteria had been met, impact on the financial services would be minimal but that if progress was made on passing the economic flexibility and convergence tests then the final two tests would also be fulfilled.

What needs to be remembered is that at this time a single currency is in use across Europe and none of the major problems foreseen by the opposition to a single currency have come to fruition. Alternatively the Eurozone has not faced any major economic problems/shocks since the introduction of the Euro and therefore there is no indisputable evidence as to how it would stand up in the face of such an economic problem. With this in mind and the fact that there are no clear, discernable economic advantages to joining the E.M.U. it is very unlikely that the U.K. will be using a single currency within the foreseeable future.

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Bibliography

Books

Atkinson B. et al. ‘Applied Economics.’ 1998, Macmillan Press, London.

Baldwin R. & Wyplosz C. ‘The Economics of European Integration.’ 2004,  

                                                                                 McGraw Hill, London.

Browne A. ‘The Euro, Yes or No.’ 2001, Icon Books Ltd, Cambridge.

Griffiths A. & Wall S. ‘Applied Economics. 10th Ed.’ 2004, Prentice Hall,

                                                                                                       Harlow.

Layard R. et al. ‘Why Britain should join the Euro.’ 2002, The Institute of

                                                                 Economic Affairs, Westminster.

Minford P. ‘Should Britain join the Euro?’ 2002, The Institute of Economic      

                                                                                  Affairs, Westminster.

Redwood J. ‘Just say no!: 100 arguments against the Euro.’ 2001, Politico’s

                                                                             Publishing Ltd, London.

Temperton P. ‘The U.K. and the Euro.’ 2001, John Wiley and Sons, London.

Journals and Newspapers.

The Economist. ‘Britain outside the Euro.’ January 20th 2000

The International Herald Tribune December 28th 2006

Websites

www.bized.co.uk

www.bbc.co.uk/news

www.brugesgroup.com

www.unctad.org

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