Will the UK Join the Euro?

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Will the UK Join the Euro?

As of 2016 the UK voted to leave the EU so the prospect of joining the euro is pretty remote to say the least. This section will be rewritten and overhauled very soon.

We will not dwell on this section. The decision as to whether the UK joins may be based on the economic pros and cons, but the final decision to purely political. The Labour government's position is currently as follows.

In October 1997, within six months of the new Labour government taking office, the Chancellor announced that the government was in favour of joining the euro in principle, but only if the UK economy passed the following five economic tests.

  1. Convergence. The UK economy must see cyclical convergence with Euro-land. This means that real GDP growth rates need to be in sync for a reasonable period of time, as well as interest rates, trade balances and unemployment levels. This is the key test. For further discussion, see below.
  2. Flexibility. This test asks the question "is there enough flexibility to deal with any problems that might emerge?" In 1997, the government felt that the UK was not quite flexible enough, although schemes like the New Deal ought to have helped. A more interesting question is, are the economies of Euro-land flexible enough, and if not, will that affect a successful UK entry into the euro?
  3. Investment. Would joining the euro create better conditions for foreign firms making long term decisions to invest in the UK? This is the controversial debate on whether Foreign Direct Investment (FDI) will rise or fall if the UK joins the euro.
  4. The City. What impact would joining the euro have on the competitive position of the UK's financial services industry? Again, difficult to call. The UK's financial services industries seem to be doing well outside the euro, but would they do even better if the UK was part of Euro-land?
  5. Jobs. If the UK joined the euro, would it promote GDP growth and, therefore, employment? This test is a little redundant because it depends almost totally on the first convergence test.

As we have already said, the key test is convergence. All the other tests are, effectively, dependent on the first one working out.

So is the UK economy converging on Euro-land?

Around this time the UK begun to converge with Euro-land. Real growth rates were very similar (both predicted to be around 3% in 2000), inflation was actually lower in the UK and, although unemployment was still much higher in Euro-land, coming down moderately quickly. The key problems are interest rates and the exchange rate.

Short-term interest rates have converged. Whereas the difference was over 4% two years ago, it is now less than 2%. This still seems quite high given how hard it is to squeeze a % change out of the MPC. The long-term rates (based on the interest rates on long term government bonds) are very similar, though.

The exchange rate is probably too high at the moment. By how much depends on which economist you believe. Some think it is as little as 5% overvalued, others think it is nearer 15%. But the pound is actually quite weak against the dollar. Many blame the euro's weakness rather than the pound's strength for the current overvaluation of sterling.

It has to be said that the UK could join the euro in the next few years. Whilst convergence with the main economies of Euro-land might not be perfect, it is better than with many of the smaller countries that are already part of the euro! The key issues are, (i) is this convergence permanent, or are the cycles just crossing over, like 'ships in the night' as Eddie George, the Governor of the Bank of England, put it, and (ii) being convergent when the UK can set its own interest rate is not the same as being convergent within Euro-land with the ECB setting interest rates.

Update 2016: Interest rates have declined in the UK to 0.5% and 0%. We are now in a world where negative interest rates are becoming more frequent!

The government has said they want to join. They agree with the single currency in principle. They are simply waiting for economy to pass the economic tests, and then a referendum will be held. If the voters want to go in, then that's it!

Will the UK Join the Euro?

Of course, it's not as simple as that. Public opinion is against joining at the moment. Many feel that if Blair gave public backing to the project, he could persuade the voters to agree, and win the referendum, just as he won the 1997 General Election. Blair will not announce a referendum unless he is sure he will win it. At the moment he does not think he can win it. Also, with the next General Election coming up, he wants to win a second term on the back of the prosperous economy rather than have a petty squabble with the Conservatives on the subject of the euro, the one issue where Hague's view is similar to the voters.

Another point to consider is that the UK might get left behind. If the UK dithers for too long and the euro does turn out to be successful, the UK will miss out on extra prosperity. One has to allow for the possibility that the other countries will not want us in if we wait too long. This is what happened after the European Community was formed in 1958. We didn't fancy it to start with, and then when we tried to join in the 60s, De Gaulle, the President of France, did not want us and kept vetoing our entry. The UK did not join until 1973 after De Gaulle had died!

Cynics say that the five economic tests are so vague and difficult to gauge that the government could sit on the fence forever, or decide to go for it in a matter of months. Hence, the decision is totally political. You must keep watching the news to understand this issue and to see when, or if, the UK joins the single currency. As these are revision notes on economics and not politics, I think it might be best to stop there!