Should the UK join European Monetary Union? (The Euro)

Member Name: Modena

Product:	The Euro
Date:	05/05/01 (1665 review reads)
Rating:

Advantages: Lower transaction costs, Helps the CAP, Good for exporters

Disadvantages: Prone to asymmetric shocks, Loss of monetary control, Further political union

The United Kingdom’s decision on whether to join the Single Currency is already a hot debate, and is likely to dominate economic and political arguments after the general election. The Chancellor has promised an assessment of five economic tests for EMU within the first two years of the general election.

I shall begin this opinion/essay by looking at these five criteria and look at the arguments for and against the UK joining the Single Currency with respect to these criteria, and hopefully answer the question of whether I think the UK should join or not.

**IMPORTANT** < Preface & Health Warning > **IMPORTANT**
This isn’t your standard if we join then the benefits are and the losses will be opinion, if you wish to read something like that then I have written an opinion on that for the other website. This is aimed at the Economics students amongst you who know a little economics and understand the statistics, this is a rather general opinion that isn’t sharply analytical. If you wish to have some information to make an informed vote, this is not really for you, read my opinion at the other opinions website.

If you’re an Economics student and you want the sources for my analysis, let me know, thanks…
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The five economic tests for EMU are:
1) Even if there are long-term benefits from EMU, are business cycles and economic structures compatible so that we and others could live comfortably with Euro interest rates on a permanent basis?
2) If problems emerge, is there sufficient flexibility to deal with them?
3) Would joining EMU create better conditions for firms making long-term decisions to invest in Britain?
4) How would adopting the single currency affect the competitive position of the UK’s financial services industry?
5) The bottom line: Will joining EMU promote higher growth, stability and a lasting increase in jobs?

The first tw
o criteria are about convergence and flexibility, these relate to the cost side of the equation. Questions three and five ask about the benefits of entry, the fourth test; financial services, is significant only because of the UK’s relative strength in this sector.

Convergence goes beyond how the UK and Euroland economies happen to be at the moment of entry, EMU entry is irreversible and ideally Euroland interest rates should be suitable for the UK economy at all times, not just at the moment of entry itself. Tethering two ships together doesn’t matter much if they tend naturally to move in convoy. It is much more costly if they happen simply to be passing each other whilst travelling in opposite directions.

If we look at the UK’s experience with the ERM, we can obtain some empirical evidence. In October 1990, the UK joined at a central parity of 2.95 Dm to the Pound, and in September 1992, it was forced out. On exit, when the Pound was allowed to float and have an independent exchange rate, sterling and interest rates fell and inflation remained stable, this suggested that interest rates and the real exchange rate had been too high. During the UK’s time in the ERM, the only way to improve competitiveness was to have lower inflation than the other members, once outside the ERM, sterling was free to fall, achieving the same result but with far less damage to output.

The reasons for sterling’s difficulties in the ERM were that sterling seemed to be overvalued at that time; the National institute valued the pound at 12% less than the central ERM parity, and there were substantial cyclical differences between the UK and Euroland aggravated by German re-unification. In 1990 and 1991, UK GDP rose by a cumulative 1.3% compared with 6% in Euroland (and 11% in Germany). Currently sterling is worth around 3.10 Dm, and this seems to be sustainable because of the UK’s relative success in controlling inflation.


Currently, because of the UK’s relatively low inflation, short-term interest rates are closer to the Euro interest rate than 1990, where the gap was at around 650 basis points. Also according to a Goldman Sachs estimate in March, the Pound is 20% overvalued against the Euro, and this takes into account the recent 9% depreciation of the Pound against the Euro.

An important consideration in looking at the first two criteria is how vulnerable the UK would be to asymmetric shocks, this is where countries face demand or supply shocks that have different and maybe opposite effects. A very simple case would be if the UK specialized in livestock and France specialized in crops and there was a shift in demand away from crops to livestock, with sticky prices and labour markets, the UK would face inflationary pressures and/or France would face a recession if the £/Fr exchange rate was fixed. Also in the absence of a flexible exchange rate, how quickly markets react (for example the rigidity of labour markets) may cause a symmetric shock to be asymmetric.

In order to absorb the effects of these shocks, there needs to be wage and price flexibility, labour mobility between countries or a flexible exchange rate. Fiscal transfers (i.e. transferring funds to the suffering country from the benefiting country) are also an instrument. A flexible exchange rate however cannot help if national borders do not represent the regional dispersion of industries, for example is southern Britain and southern France specialized in crops and northern Britain and northern France specialized in livestock, changes in the £/Fr exchange rate will not ease adjustment.

Are labour markets and prices flexible in the UK? If we base the first question on trade union legislation, then we are more flexible than our Euroland counterparts. If we look at labour mobility, firstly starting with labour mobility across Europe, then this is very low, especially compared with the US.
Across the UK the figure is likely to be much lower than the whole of the US also. Price flexibility can be measured by the steepness of the short run aggregate supply or Philips curve, but recently, inflation has been relatively stable, so any efforts to determine this will not be too credible.

What matters is how often these asymmetric shocks happen, if these happen all the time, then national economies might find themselves with inappropriate interest rates, if they happen rarely, then a single interest rate will cause few disruptions. Also if there is more convergence, then countries will be able to deal with them in a more symmetric way. There are two views as to whether asymmetric shocks will be more or less likely, one is that as Europe becomes more integrated, it will specialize, like the US, if this is true, then asymmetric shocks will be more prevalent, this is the view adopted by Economists such as Krugman. Another view, adopted by the European Commission is that more integration leads to less divergence, because economies of scale are not that important, especially in the services sector, and also because of consumer’s love of variety, also as economies become more integrated, their business cycles become more correlated and national boundaries become less relevant. If this is true then there are likely to be less asymmetric shocks.

Has the UK become more synchronized over time with the Euroland? If we look at data where the UK growth rate is regressed with Euroland and the US for the period 1980-1992 and 1993-2000, we see that it has become less synchronized with both parties. The coefficient on European growth, has fallen slightly from 0.19 to 0.14 over the two periods, but its significance has fallen (from a t statistic of 1.5 to 0.8). US growth, pre 1992, was reasonably correlated with UK growth, the coefficient was 0.32 (t statistic 2.7) but post 1992, it has become irrelevant (coefficient 0.09, t statistic 0.7), this refle
cts the US’ acceleration of growth post 1992. Overall, the US and Europe can explain less than 10% of the movements in UK growth since 1993, compared with almost 20% during the earlier period.

Another way to look at convergence is to look at interest rate movements between countries. If there are similar shocks, then monetary authorities are likely to react in a similar way. If we regress the changes in three-month UK interest rates on changes in US and Euroland interest rates, then we can see that interest rate movements have been better correlated across countries than GDP growth rates, at least since 1993. The coefficient for Euroland has moved from an insignificant 0.21 to a significant 0.44 between 1980 to 1992 and 1993 to 2000, with even more correlation with the US, from an insignificant 0.06 to a significant 0.56, suggesting that our interest rate movements are more correlated with the US’ (a statement reinforced by the stability of the £/$ exchange rate). Together, these movements, pre 92, explained 2% of the UK’s interest rate movements, but post 1992, they accounted for half of the UK’s interest rate movements. So half of the UK’s interest rate movements could be reflecting similar conditions abroad, and the other half reflects shocks common to ourselves. Of course, this does not just imply greater convergence; it could simply reflect the relative success and stability of UK monetary policy since inflation targeting was introduced.

So, there is greater evidence of stronger correlation with UK/Euroland interest rates since 1993, but there is still considerable independent variation in response to asymmetric shocks. It remains unclear whether the UK has truly converged with Euroland. It is not obvious that the Treasury will be able to reach a stronger conclusion with one or two years more data.

So far I have looked at the first two criteria, the potential costs if there is an inappropriate monetary po
licy, and these costs will be reduced if the UK economy becomes more flexible. The benefits from monetary union will primarily arise from enhanced trade.

The third criterion concerns how entry into EMU will affect long-term investment decisions. The government is probably more worried about foreign and domestic companies deciding to switch investment from the UK to Euroland should Britain not adopt the single currency. Certainly big firms such as Vauxhall and some Japanese car manufactures have “threatened” to close more or open less factories in the UK if Britain should choose not to adopt a single currency.

Evidence suggests that currency unions enhance trade flows and this boosts income per head. With floating exchange rates, there are two types of costs incurred, first there is the cost of currency conversion, and possibility the need to use future markets (This is expected to save between 13-20 billion ECUs a year or a quarter to half a percent of European GDP), and the second is that returns on overseas investment are subject to exchange rate uncertainty. Volatile exchange rates destabilize the economy and hinder trade. Imagine each US state having a separate currency, there would be much less trade. However volatility also leads to unexpected profits, thus this weakens the argument. I guess excessive short-term volatility is not as painful as a medium term misalignment.

There are a lot of estimates as to how much more trade EMU will lead to, some studies claiming up to 50%. Given the figure of 50%, this means the UK will export and import 6% more of it’s output. However this study was based on colonial powers and their former colonies, thus they could have close trade links for reasons other than a common currency.

Trade allows production to be more specialized, countries will be able to exploit their comparative advantage. If there is free trade, sources of increasing returns to scale can be better expl
oited. Many modern, information-driven industries require a large base before production becomes economic. More trade also means more competition and lower prices; this potentially leads to more innovation and an increase in productivity.

Recently, Romer and Frankel found that increase in trade by 1% of GDP is associated with an increase in income per head between 0.5 to 1% (and there is also a dual causality). Given this and the 6% increase in trade flows, GDP and income per head in the UK will be boosted by 3%. Other estimates, (the Cecchini report) show a one-off effect of around 2.5-6.5% of European GDP and Baldwin estimates the medium term growth effects to equal 30-100% of the static effects, thus adding to at least 3/4 to 13% to growth rates, which is significant.

The remaining question posed by the government is how EMU will affect the UK’s financial services sector, there were fears that the UK’s decision to stay out of EMU would threaten London’s position in the financial services sector. In 1995, London accounted for 60% of Eurobond issues and 70% of their secondary trade. London’s share of over-the-counter derivatives trade and foreign exchange transactions were 27% and 30% respectively, both higher than in any other single location. Since 1995, London’s shares of eurobond, foreign exchange and derivatives trades have all risen. Together, securities and money market dealing added £1.7bn to net exports in 1995, in 1999 these were worth £3.0bn in exports.

So will the UK pass these 5 economic tests? At this point in time, it would seems as if there is far too little conclusive data to go by, but based on the arguments, there does not seem to be too much to gain relative to the potential losses. Many economic commentators conclude that EMU seems to be a political issue rather than an economic one. The single currency itself is not even in circulation, it may be beneficial to wait and see, and if it
is appropriate, join at the right time, there does not seem to be too much to lose if we play the patient game.

My yes/no answer to whether Britain should join EMU would be a no for now, I think it is a little early to decide, especially before there is any hard evidence of the potential gains being realised and questions about asymmetric shocks, it would also be interesting to see the costs of adjusting to Euro notes and coins to be experienced by Euroland members. There is also the question of whether the Government (which everybody expects to be re-elected) can win an EMU referendum, especially because the public seems to be anti-EMU at this point in time, losing this may be too damaging politically

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