Should the UK Join the Single Currency?
Should the UK Join the Single Currency?
It would not be too strong a statement to say that the decision as to whether the UK should replace the pound with the euro is certainly the biggest economic, and perhaps the biggest political, decision since the Second World War. The government are committed to holding a referendum (a vote of the general public) as to whether or not to join after the May 2001 election, once Gordon Brown's five economic conditions have been met.
Many of you will be old enough to vote and it could be one of the most important votes of your life. Even if you hate politics, as an educated individual you really ought to have an opinion as to whether the UK should or should not join the euro. The arguments are outlined below.
Probably the biggest advantage of joining the euro is the fact that our exchange rate will be stable against the other eleven members forever more. Over half of UK exports and imports come from trade with the EU. The stability for these exporters will enable them to plan more easily and investment is likely to rise. It will also encourage further trade between these countries, which should lead to further economies of scale.
There would probably be more stability with interest rates too. The seventeen-member council of the ECB come from eleven different countries with varied vested interests, so consensus, and therefore a decision on interest rates, tend to be less frequent than with the UK's MPC, who only have to think of the UK. Of course, that is why the MPCs decisions tend to be better!
Many economists think that this is one of the biggest advantages. At the moment, comparing prices between countries is difficult due to the numerous different exchange rates. If the UK was part of the euro, all prices would be expressed in one currency. Prices would be transparent. A British consumer could easily compare the price of a car here to one in euro-land. This will force firms to be more price competitive, unable to hide behind a changing exchange rate. This should result in lower prices for all consumers.
One can be a little cynical about this advantage. Surely, anyone with a calculator and some basic arithmetic skills can already work out the prices of goods in foreign countries. We have to do it all the time when we go on holiday abroad. Also, whatever the unit of currency, how is a hairdresser in Spain going to compete with a hairdresser in the UK? Unless the product in question is a big-ticket item, like a car, where British consumers are already prepared to cross the channel in search for cheaper deals (whatever the currency), then little EU wide competition will occur.
This is the most obvious advantage. If we share a currency with the rest of Europe, there will be no need to pay transaction costs of changing currencies when you go on holiday. This 'convenience' factor is probably the one that impresses the non-economist the most, and will play well for those hoping that the general public vote for the euro in a referendum.
Of course, this is a bigger advantage for businesses whose transaction costs are inevitably higher, as it includes the costs of hedging against huge currency swings. It is, though, an advantage that is worth less than 1% of EU GDP. It may be the most visual advantage for the general public, but it is not the most important economic reason for joining the euro.
FDI is a contentious issue. Some economists believe that the UK will attract more FDI if they are part of the euro. Foreign investors want to take advantage of all the benefits above. Others argue that joining the euro will harm FDI. At the moment, foreign investors still get the benefits of the UK being part of the EU without any of the disadvantages listed below. It is a difficult one to call, although FDI into the UK has still been growing since the euro was created without the UK's presence. See the topic called 'The balance of payments' for more discussion of FDI.
Before the launch of the euro, Germany was traditionally the strongest economy in Europe. One of the main reasons for this was its excellent record on inflation, which many felt was down to its highly efficient independent central bank, the Bundesbank. It was hoped that the independent ECB would be equally efficient, keeping inflation low and controlling government spending around euro-land with the stability pact. The UK, with a traditionally poor record on inflation, should benefit from the ECB's efficient running of the Euro-land economies.
As discussed above, the tables have turned with the UK's MPC attracting praise for its running of UK monetary policy and the ECB, whilst not a disaster, certainly not in the class of the old Bundesbank. Why join the euro, many ask, when things are going so well in the UK outside the euro. "Better the devil you know..." as the phrase goes!
Loss of domestic monetary policy
This disadvantage seems to ring louder by the day. As the UK's MPC gains credibility, it seems a shame to give it up and allow UK monetary policy to be subsumed within the remit of the ECB. This is a problem for many countries in Euro-land. One currency means one interest rate. Even those who are in favour of the euro would have to admit that the interest rate set by the EBC for the whole of Euro-land will not be ideal for all eleven countries.
The classic example is Ireland, who joined the single currency at its inception with domestic interest rates at 6% (like the UK) and the economy growing well without inflation (like the UK). On entering the single currency, their interest rate had to be set at the ECB rate, which, at the time, was 3%. So Irish interest rates fell from 6% to 3% overnight. If that had happened in the UK there would have been a boom followed by inflation and then recession. Ireland is at the beginning of that cycle, with inflation rising very quickly.
The whole point of the convergence criteria as a condition of entry was that all the economies that qualified would have 'converged' and would then grow and shrink together on the same economic cycle. Interest rate decisions would be 'OK' for all countries. But just because a set of statistics match on a particular day does not mean that economies are moving in the same direction. One could be rising and the other falling, but they happen to meet in the middle - ships passing in the night!
This is the biggest disadvantage of joining the euro. The more credible the MPC become in terms of running UK monetary policy, the more risky it looks to let the ECB take over.
Lack of fiscal transfers
The USA is, in a sense, a single currency area. The economy of California is totally different from that of the state of Mississippi, and yet they survive with a single currency. One of the reasons is that they have a federal (national) government that can set federal taxes to raise revenue and help states (or economies) that are suffering.
Although the EU does have a budget, it is made up of contributions from the member states. There are no EU taxes. The budget is a tiny percentage of EU GDP. If an economy in Euro-land is suffering, it can no longer devalue its currency against other Euro-land economies, and it will receive no help in terms of money from the centre. It will just have to work its own problems out, probably through a period of unemployment.
To make matters worse, the stability pact that the member countries have signed up to means that their annual budget deficits cannot exceed 3% of GDP (the same as the Maastricht criterion for government debt). Countries in trouble will not even be able to borrow money to help themselves in times of trouble.
Variable rate debt in the UK
This is a disadvantage specific to the UK. In the UK, not only do a high percentage of the population own a home rather than rent, but also many more of the mortgage holders have variable rate debt than in EU countries. If the UK was part of the euro, any change in the interest rate set by the ECB, whether sensible or not, would have a much bigger impact in the UK.
A rise in the interest rate would cause the mortgage payments of all those who have a variable rate mortgage to rise. They would have less disposable income, so consumption would fall. There would be an equally big swing the other way if interest rates rose. This is why many economists argue that UK interest rates should be set separately from Euro-land interest rates. The subsequent effects are too different for the same interest rate to work for the UK and the rest of Euro-land.
Labour market flexibility
Most economists agree that the UK has a more flexible labour market than Euro-land. We are finally reaping the benefits of all the reforms of the 80s (see the topic called 'Labour markets' for details). The UK labour market is still not very mobile, though. The Euro-land labour market is neither flexible nor mobile.
Looking back at the American economy again, its labour market is fairly flexible and very mobile. If an American loses his job in one state, he can move and find a job in a more prosperous state. Crucially, the language and the culture are the same. This will never be the case in Euro-land.
Without flexibility (in terms of wages as well as the conditions of employment) and mobility (geographical and occupational), it is difficult for countries within Euro-land to sort out large unemployment problems. They can't change their interest rate on their own, they can't ask for money from the EU, they can't borrow excessively themselves to fund the problem and now their unemployed workers are not very mobile or flexible when it comes to finding another job.
The UK is better in terms of flexibility, but does it want to join the single currency when the other members do not seem to being doing much about their inflexibility (to the detriment of the whole project)?
The decision is a difficult one. The advantages are more clear-cut and definite. The disadvantages look horrible, but are less certain. Certainly the degree of unpleasantness is difficult to predict. If the project works over the medium to long term, the UK would definitely want to be part of it. The UK would be economically better off. Essentially, the key question is, would the benefits of price transparency and stability be outweighed by the loss due to the handing over of monetary policy to the ECB?
Some politicians do not want to join however good the economics looks. Many feel it is a political, rather than an economic, project. The goal of the devisors of the single currency was a single government. In other words, a federal United States of Europe (like the USA). Decisions made and taxes set centrally in Brussels on top of the interest rate decisions that are already made centrally (i.e. by the ECB). If the UK government loses the power to set its own taxes then what is it? A regional devolved government subservient to an all-powerful Brussels, just like local government has little power in the UK at the moment? Of course, the project will not necessarily go that far, but the euro-sceptics can paint a fairly apocalyptic picture, as you can see.
There is one very good analogy. Imagine that you are about to take a flight that will take you to the Caribbean and a well-earned, enjoyable holiday (that's the good part - joining a successful single currency). You are told before the flight that there is something slightly wrong with one of the engines, but the chances of anything going wrong are very small indeed (the chances of the euro project going completely wrong are also very small).
Would you get on the plane?