User:Sam Francis/The Euro

The following is a report I wrote in 2001 for my economics a-level. I'm posting it here in the hope that it might help improve wikipedia. Most of it is fairly NPOV, although some of it is written from the first person. There were a few graphs that are referred to in the text, and I can reproduce those if anyone thinks they would be useful; just comment on the talk page. (In the article, "we" refers to the UK. Also, note that my views have probably changed since this was written.)

This may help with articles such as Euro, European Union, Single European Market, perhaps some of the economics articles.

Should the UK join the Euro?

The Euro, the single currency currently in use by twelve of the fifteen member states of the European Union, is the prime feature of Economic and Monetary Union (EMU), which can be identified as the fifth stage of economic integration (of which there are six stages). The currency is to come into physical form on the 1st of January 2002. The United Kingdom is currently one of three EU states not participating in EMU. This question is therefore very topical; whether the UK joins the Euro or not will be an important decision and will have a profound effect on the country economically.

To answer this question, I intend to look at the economic situation of participating EU states (known as "the Eurozone") as one body, and that of the UK, to see if EMU would work as it is intended, whether it would benefit the UK economy, and whether or not it would be better for the UK to join or not, from various viewpoints including stability and trade. I will also investigate how the UK economy would react and be affected by joining or staying out of the Euro, and assess the economic benefits and disadvantages. I will discuss the implications of joining, such as the centralisation of interest rate decisions, and finally evaluate whether or not it would be in the best interests of the UK, from an economic point of view, to participate in EMU with the twelve other European countries involved.

Economic concepts & theories

The following economic concepts and theories will be very important to my investigation:

Inflation (a sustained increase in the general price level).

The introduction of the Euro itself may cause inflation, and inflation, as a measure of economic performance, is a useful indicator on convergence.

Monetary Policy (a method of managing the economy mainly utilising interest rates to control inflation)

If the UK joins the Euro, monetary policy decisions would no longer be made by the Monetary Policy committee (MPC), but would be handed over to the European Central Bank (ECB). This centralisation of monetary policy (‘one size fits all’) is a possible source of economic problems stemming from regional differences.

Unemployment (the proportion of the population not in work)

EMU itself may cause some unemployment as markets adjust to the new competitive conditions. Also, significant variations in patterns of unemployment would suggest that the economies are at different points in their trade cycles, which has implications for EMU.

Exchange Rate Risk (the risk for firms when dealing with more than one currency)

This will be eliminated for trade within the EU, and so firms and consumers will be able to truly find the lowest price available in the EU (due to price transparency), and so exploit fully the benefits of the single market.

Theory of Comparative Advantage (the theory that total output will be increased if each country concentrates on producing what it is relatively best at)

The advantages of this theory may be more fully exploited with EMU, as trade within the Euro-zone increases.

For and Against

Arguments for joining

The primary arguments for joining can be summarised as follows:

There would be less trade barriers with other Eurozone countries, which already make up the majority of export markets. This should have a deflationary effect and benefit economic growth.
The UK would benefit from increased competitiveness from the positive results of competition (namely, efficiency).
The UK would have more of a say in what happens politically and economically in its most important export markets.
With the benefits of trade and the SEM more fully exploited, the UK will see great economic benefits from EMU, particularly economies of scale.

Arguments for staying out

There are arguments in favour of staying out of the Euro. The main ones are:

The single currency will cause instability while economies adjust. For example, the exchange rate will fluctuate (since its creation, the Euro has fallen to about 60-70% of its original value against the dollar) and the introduction of notes and coins will cause disruptions.
Once in, we will be locked in, and we cannot get out of the single currency: there’s no turning back. So, if the currency fails and becomes unworkable for whatever reason, or causes problems like inflation, we will not be able to leave it, and will have to suffer the consequences in whatever form they might be (unemployment and recession, for example).
Political arguments, such as fears that the Euro is a step towards undesirable political union with the EU states, are abundant on this issue.

Monetary Policy - Interest Rates

The Bank Of England currently controls interest rate decisions in the UK. If the UK joins EMU, these powers would be given to the ECB, which already controls bank base rates in the twelve Euro-zone countries. The question is whether or not this is a good thing for the UK economy.

The argument for giving up these powers is that, although it may happen at times that the UK economy is out of step with the rest of the Euro-zone and so may require different interest rates, this can be compensated for using other methods of controlling inflation and the economy. On entering into the Euro, the government will be giving up two of the four methods available to it for controlling the economy - monetary and exchange rate policy. The two remaining tools left to the government are therefore price and incomes policy, which involves placing legal controls on price and income changes, and fiscal policy.

Fiscal Policy

Fiscal policy involves using the ‘levers’ tax, government spending and borrowing to manipulate aggregate demand. For example, by cutting taxes, a government hopes to encourage spending to bring the economy out of recession.

However, there are problems with using fiscal measures. First of all, the extent to which any EU government can alter taxes is restricted because of harmonisation - a philosophy followed by the EU to achieve the Single European Market, making each country as desirable as any other for consumers and firms in terms of taxes. For example, changes to value added tax (VAT) are restricted. Also, it is politically difficult for the present Labour government to increase taxes because of the electoral promises they made.

The argument against fiscal measures is a historical and political one; in the past, governments used fiscal measures to a much greater extent, but found that fiscal measures - particularly government spending - although politically popular at times, did nothing but fuel inflationary pressures in the economy and cut or boost aggregate demand temporarily. The abandonment of fiscal policy as a primary measure came in the mid-1970s, following the disastrous boom of 1972-3, which ending with the oil crisis of 1973 and world recession in the following years. Jim Callaghan, Prime Minister in 1976, told a Labour party conference, "We used to think you could just spend your way out of a recession...that option no longer exists, and that in so far as it ever did exist, it worked by injecting inflation into the economy."

Price and incomes policies

Price and incomes policies are also now looked upon as undesirable - especially as they conflict with monetarist and free trade philosophies. These measures are likely to make the UK a less attractive location for foreign investment, and so would not be desirable in the free market situation that the world at large - particularly the biggest economies of the world, and the World Trade Organisation - is pushing for. The EU in particular is one of the most successful symbol of this ideology, as economic integration has led to increases in trade between EU nations. In this increasingly free single market, the UK economy has to stay competitive, and government restrictions and intervention is not likely to help this.

The largest single market in the world - the US The United States of America, with a GDP of £6127 billion, has a single currency: the dollar and so there is just one interest rate in the US, set by the central bank in Washington. The huge US economy thrives with this one rate. However, where interest rate policy would be used, instead the US has movements of labour and finances (through taxes and spending). Although the EU does have some similar arrangements in financial transfers - called Regional Development Funds - there are major differences in the US and EU labour market. Labour in Europe is immobile compared with the US. This immobility, something which the SEM was aimed to combat, is caused by cultural and language barriers.

All of these arguments over the "one size fits all" interest rate are, however, based on whether or not the UK economy is out of step with those of the Euro-zone. If this is not the case, then one interest rate across Europe would have no ill effects, and would make the SEM more competitive, as the economies would be on a level playing field, as it were.

Convergence with the Euro-zone economies

It is important that the UK economy is in-step with that of the Eurozone, particularly because of the centralisation of interest rate decisions outlined above. To find out whether or not this is the case, I will look at various economic indicators for the UK and Eurozone (mainly) and see whether or not there is any correlation in the patterns that they follow.

To join the Euro, it is preferable that the UK economy is at a similar point in the trade cycle to the Euro-zone, particularly if the "one size fits all" policy of the ECB is to be effective in keeping the economies of the Euro-zone from overheating with inflationary pleasures. Figure 1 therefore shows a comparison of three rates of inflation; the Euro-zone average, the EU (as fifteen countries, hence "EU-15"), and the UK rate. The first two are measured in the "Harmonised Indices of Consumer Prices", which is designed for international comparisons of consumer price inflation.

This graph shows that although fairly in line in the last quarter or so of 2000, since February 2001 the UK rate has followed a different pattern to the rest of the EU. The UK rate has dropped significantly in the first half of 2001 but has otherwise been following the same pattern to the EU average, if at a lower level. It is interesting that the Euro-zone has been experiencing consistently slightly higher rates than the EU as a whole. This suggests that the three countries that have stayed out of the single currency to date (Denmark, Sweden and the UK) have been experiencing lower levels of inflation in general. However, more detailed data would be needed to draw reliable conclusions from such a suggestion, and I will investigate this later.

The data shows that the UK inflation rate is not completely in line with the EU or Euro-zone averages. However, the UK’s rate is, and has been for some time, at a similar level to the EU and Euro-zone averages, and does follow a broadly similar pattern, even if it has deviated from the average in recent months. UK inflation has been relatively stable over the past few years - perhaps due to the success of the independent Monetary Policy Committee - as the German inflation rate has historically been.

Joining and inflation

According to figure 1, there seems to be no great upward trend in the Euro-zone. This is perhaps an indicator of what the Euro would do to inflation upon joining the Euro. A survey by the accountants KPMG showed that "within a year of its launch, 40% of Euroland firms had cut prices because of the single currency."

Price transparency, the idea that it will be easier to compare prices across the Euro-zone because of the single currency, suggests that EMU would have a deflationary effect in the short term, as firms adjust their prices in a more competitive environment. The benefits of this to Britain will be large, because British prices are already quite high, hence the term "Rip-Off Britain". The use of the internet by consumers - and perhaps more importantly, by businesses - to find the lowest price will further price transparency, increasing knowledge in the market and so making it more competitive.

The fact that the EU-15 rate is lower than that of the Euro-zone shows that non-Euro countries have had lower rates of inflation on average, as mentioned above. This is, however, far from conclusive evidence that the Euro is bad for an economy. There are a number of reasons why this difference could exist:

The Euro-zone could be experiencing inflationary pressures because of the changing nature of monetary and financial systems, due to the anticipated introduction of the Euro as physical currency (in January 2002) and possibly also the introduction of the Euro as electronic currency. There is a strong argument that these pressures will subside.
One or more countries could be not suited to the Euro, or simply experiencing economic difficulties, and so dragging the Euro-zone average up.

As the date of the introduction of physical currency approaches, businesses in the Euro-zone will be spending increased amounts in preparation for the changeover, especially large retail outlets and financial organisations who will have to deal with the Euro on a particularly large scale, as they have to have a lot of working capital. There are so many spending implications for the changeover of currency: in training of staff who have to deal with it, public information by governments wishing to inform their citizens about the new currency and the changeover, replacement and upgrade of machinery that deals with physical currency, the list is seemingly endless. All these, then, will contribute to inflationary pressures in the Eurozone, and are likely to drag the Eurozone inflation rate up above that of the EU-15.

However, there is a counter-argument to this. Because the ECB sets interest rates for the whole of the Euro-zone - discussed earlier - and the whole Euro-zone will probably experience the same level of inflationary pressures from the introduction of Euro notes and coins, interest rates in the Euro-zone should have compensated for this. It is possible that they have, and that inflation would be much higher had they not. This argument is a worry for Britain joining, as it may mean that if we do, the introduction of physical currency and related inflationary pressures will be at a different date to that of the rest of the Euro-zone, so the UK economy would be put in danger of overheating without monetary policy measures available to the government.

It is also possible that these inflationary pressures have simply offset the effects of the US recession by sustaining business and government spending and investment.

Gross Domestic Product: Economic Growth

The change in GDP is a useful measure to show whether or not economies are growing at similar rates, and we can use it to determine whether or not economies are at similar points in the trade cycle.

Figure 2 shows that the UK’s rate of growth has been roughly in line with that of the EU as a whole and the Eurozone. It also shows Luxembourg and Ireland’s growth rates, which are the highest in the Eurozone. It is interesting that both of the latter follow the same pattern, although at different levels. This suggests that, although they have high growth rates, these are changing at similar rates to each other and to the UK and the rest of Europe. This is good evidence that the European economies are roughly in step: especially the close correlation of the UK and European patterns.

And why shouldn’t this be so? The UK is still, after all, a member of the Single European Market, and in theory trade barriers are steadily being removed to make for a freer market. This makes trade with the EU generally a more attractive option than trade outside the EU.

Figure 3, below, shows economic growth over a longer period. This also shows a UK correlation with the EU, as well as with the US. This is significant, as it shows that, over the longer term, economic growth in the EU and US are very much in line. This is important because, even if the UK’s trade cycle is in line with the US’, as the argument goes, it is also in line with the EU’s: the three correlate. Even the Japanese growth rate, which differs immensely from the others, still follows a similar pattern of ups and downs (until very recently).

Inflation and Economic Growth

The above proves that the economies of the UK and Eurozone are fairly in synch, even though there are regional differences, such as the difference in growth rates between Ireland and the EU average.

Benefits from the Single Market

The European Commission estimates (in the Cecchini report) that the EU has gained in 4.3-6.4% of its GDP from the single market, due to gains from increased competition, removing barriers and exploiting economies of scale. Assuming this is an accurate figure, this would imply that similar benefits would arise from the single currency, as it opens the market further, and will have similar effects on trade barriers and competition.

However, opening markets in this way tends to have some adverse effects in the short run. Unemployment is an example of this: where markets are opened up and competition increased, some firms, the least competitive, will be forced to close, causing unemployment as the economies adjust to new competitive conditions. Further down the line, though, it is likely that this will be offset by increased economic growth which will in turn increase employment.

Trade

One common argument against this synchronisation is that the UK’s economy is closer to that of the USA, because the USA and UK are major trading partners - US investment in the UK is double that of its investment in all of the other EU countries put together. However, as figure 4 clearly shows that although the USA is one of the countries with which we trade the most, exports to the EU make up the vast majority, making the EU as a whole our most prominent trading partner.

There are many reasons for the EU being our main trading partner. Two of the most important are:

Geographic proximity
The single market.

Both help to make goods cheaper (reduced transport costs; less trade barriers) and so increase the likeliness of trade with the EU states.

The single currency makes it easier for countries to trade with each other, for a number of reasons:

There are no problems with exchange rates; such as exchange rate risk for businesses.
Financial documents and communications used in internal Eurozone trade will be more simplified, with only one currency to worry about, making trade easier and quicker.
Prices across the EU will be transparent; i.e. consumers can evaluate what the price of a product is without having to calculate the exchange rate.

These serve to lower production costs, which will have two effects:

Deflationary effect. Lower producer prices will lead to lower consumer prices.
Increased international competitiveness.

Also, consumers will see less costs in changing money when they move between countries. This could help labour to be more mobile, and will increase consumer confidence in buying between Eurozone countries, especially using methods like the Internet, so encouraging spending. Price transparency will also be a benefit to UK consumers, furthering these factors.

Long Term Benefits of Trade

The theory of comparative advantage states that total output will increase if countries focus production on what they are relatively best at, hence implying that a country’s specialisation is desirable if the aim is to increase total output. This theory is generally accepted, so countries specialise in various areas according to their advantages. Therefore, countries tend to need to trade with other countries for goods that they produce cheaper.

If total output is increased, as it will be in a free market where trade is easier (according to the theory of comparative advantage), it can be assumed that this will generally lead to greater economic welfare, as more goods are produced, and so people have more of their needs better fulfilled. Also, the cost of living should decrease because of lower prices rooted in benefits like economies of scale and increased efficiency from competition which are brought by freer and larger markets, such as the Single European Market (SEM). Not only will welfare be increased, but an increase in total output implies economic growth. With the level of integration in the EU, this will most likely effect both parties positively.

The Greater Benefits

The EU has a pot of money which the various states contribute towards and are given what is deemed necessary. The UK, for one, contributes more than it gets back from this pot. The philosophy behind this kind of aid is not just concerned with the welfare of the various EU economies. By helping other countries (our trading partners) economically, countries benefit from greater consumer markets. This is an application of the Darwinian idea of "mutual aid", ie. cooperation. This will help each country, and is an example of where investment can be more effective from one country to another. For example, the multiplier effect of, say, an infrastructure investment like improving roads will have a greater effect in a poorer EU economy like Portugal than the same amount would have in the UK. We have seen that the UK loses money directly to the EU, but in helping our trading partners economically, we are increasing the markets available to our companies and suppliers available to our consumers and so the benefits are coming back to us.

The same is true of pulling down barriers to trade. Whether the increased trade benefits the UK or other EU countries more is irrelevant; both parties will benefit indefinitely from increases in economic growth and welfare, and the EU would support any economy that is initially disadvantaged through its spending.

The idea illustrated is that by helping other economies (particularly as those economies are some of our most significant trading partners), we will help ourselves by effectively increasing the size of our own markets in terms of consumer spending power and disposable income.

The views of other economists

Kenneth Clarke

As an ex-chancellor, Kenneth Clarke speaks with some authority as a free market economist. In a speech to economics students in London recently, outlined why the Euro was desirable when the economic conditions were right for the UK to join. The points he made were that the single currency is based on the same principle the single market (I have already briefly discussed the benefits of this) and so is an obvious and planned extension of this move. He also said that the UK economy was fairly convergent with that of the other big European economies - Germany and France. Low and stable inflation rates are something we share with these countries. The fluctuations of the pound against other European currencies - which would be elimanted with the Euro - are damaging to trade and investment, and eradicating them would be to the advantage of the UK economy.

The ‘left wing’ view

Left wing economists and politicians, such as the ex-Labour MP Tony Benn, are not advocates of free market economics in general. Their argument is that in the free market system that is being created, corporations become hugely powerful, and Tony Benn called this corporate power a "threat to democracy", pointing to the fact that Ford - the car manufacturer - are in fact larger than South Africa in terms of budget, and Toyota larger than Norway.

The single market in Europe, and the single currency as an extension of this, is very much a free market idea, and is partially based on the model of the United States as a successful economy. Tony Benn, for one, challenges this model by pointing out that in the US, 40 million adults have no provision for healthcare. Cuba, a socialist command economy and neighbour to America, in contrast, has universal healthcare. Generally, then, left wing economists oppose the opening of markets advocated by free market economies, largely on the grounds that it leads to the easier exploitation of people by powerful corporations. Although this, as an argument against free market economics, is not directly applicable to the Euro, the EMU, like the SEM, is built on a free market philosophy, and so is in ideological conflict with the left wing view.

Also, many left wing economists advocate decentralising political (and economic) power, and putting decisions into the hands of the people it effects. Centralising decisions in the SEM in general, and with the interest rates and the ECB in particular, is therefore very much contradictory to that, and a single currency leads to centralisation of economic decisions.

Validity of data

While making selections from the huge amount of data available, I had to make sensible choices about which data was relevant and valid. The potential problem with this is bias; each source may have some element of bias, which can usually be offset by using a variety of sources. I used a relatively small variety; and a lot of the data, that could be relied upon to be fairly accurate, came from a small range of sources, such as Eurostat and the OECD, which have a small potential for political bias. On the other hand, for purposes of historical comparison, getting data from one source will help, as you can be fairly certain the data was collected in the same way over the time period, making comparisons over time more valid.

The following conclusion is based on the arguments and findings from the rest of this report. There are a number of problems that could arise from this:

Personal bias. I, as the sole author of this report, have made all the selections of data and findings contained in it, and so there is a possibility that the report as a whole could be bias towards, for example, my political views. I have tried to keep this to a minimum, however, by using my critical faculties to remain as objective as possible and see the arguments from both sides.
Assumptions. Economists have to make a wide range of assumptions, usually to facilitate economic models. There is always the danger that, in reality, these assumptions may be widely inaccurate, resulting in inaccuracies in models and the arguments that arise from them. It is intellectually healthy to challenge these assumptions, and ensure they are justified and have some bearing on reality. Arguments that are based on many assumptions will be less valid than those that aren’t, and it is the same for economic models.

Conclusion

In the long run, EMU will bring great economic benefits to the UK. In the short term, there may be problems arising from the introduction of the Euro, especially in the transition period, when both the Euro and Pound Sterling would exist in physical currency at the same time. However, these problems will be temporary, and should hopefully pass by without any great long term effect. Also, we will be able to observe the coming transition in the Eurozone because of our late entry, and so learn from the Eurozone states’ experiences.

The opportunity cost of not joining the Euro is great. Multinationals and foreign companies (such as Asian companies) will find it easier to deal with just one currency across Europe, and so UK businesses would lose out on commerce and the UK on investment by foreign companies, simply because these companies find it more convenient to work in Euros. Trade with the Eurozone will also be discouraged because of the currency barrier that would then exist between the UK and Eurozone (as this would not exist within the Eurozone).

The argument that there is a choice to make between becoming closer with the EU or US economies are flawed. If the UK stays outside the Eurozone, it may well become closer to the US economy. However, it will (as outlined previously) distance the UK economy from EU commerce. Closer economic ties with the US might even mean, at this uncertain time for the US economy, that the UK economy is dragged down with the US to a greater extent than it would otherwise be, in the event of a major US recession. If the UK does participate in EMU, we will undoubtably become closer economically with the Eurozone (and hence the majority of the EU). This will not, however, result in distancing from US trade. It may even benefit us in terms of trade with the US, as the Euro exchange rate to the US Dollar may make our exports more competitive in US markets. In this uncertain period in the US economy, joining the Euro may also safeguard against the effects of a major US recession by increasing trade between the European nations.

The world - rich nations in particular - is already following a policy of opening up markets, the EU itself is an example of this. It is therefore sensible for the UK to participate in this to open up trade even further in the SEM - and this means participating in the Euro. Such policies tend to have short term disadvantages - such as unemployment as uncompetitive firms are rooted out - and longer term advantages, such as gradual gains in GDP growth.

The UK should therefore, after observing the effects of the Euro in the 12 countries now taking part, should look to the future, take a calculated risk and participate in EMU to maximise the benefits of the Single European Market and gain further from closer integration.