Should Britain Join the European Union

With the change over to the Euro notes and coins now complete across the “Euro-zone”, twelve countries that have adopted the Euro as their currency, the debate over whether to adopt the single currency in Britain continues. There will be those who argue that the introduction of the single currency is merely the next logical step in the development of a truly single market, and that by joining, Britain would gain a voice in what could eventually become the world’s most powerful economic zone.

Others believe that a successful common market is not dependant on the adoption of a single currency, which they see as merely another irrevocable step towards the political union of Europe. But the main focus of the debate centers on the parameters of macro economic objectives. So, assuming exchange risk is a big factor, consider whether joining the Euro will actually reduce it or not and if so by how much. Here we immediately trip over the key point that joining the Euro is not to join a world currency but a regional one.

Unfortunately for our exchange risk we trade very heavily with the dollar area. Let us not get tied up in the vexed question of the exact shares of our trade with Europe and with the USA, and what sorts of trade should be counted (in goods? in goods and services? or in all cross-border transactions including foreign investment and earnings on them? ). The point is that if we regard exchange risk as a sort of tax on transactions involving exchanging currency, then it is plain that the broadest definition should be used for the ? trade’ affected by this tax.

Most of the world outside Europe either uses the dollar or is tied to it in some formal or informal way. We might then say, in a rough and ready way, that we trade and invest half with the Euro area and half with the dollar area. It so happens that the Euro/dollar exchange rate has been highly variable for a very long time – see Figure 1 which shows the DM/dollar rate up to January 1999 and thereafter links on the Euro-dollar rate (this linkage assumes that the DM would have been the dominating element in the behavior of the Euro, had it existed before).

Nor have the sources of that variability been removed. They include the very different philosophies of regulation which lead to swings in market sentiment about likely future success; differences in business cycle timing which cause swings in interest rates; and differences in adoption of new technologies. It is true that differences in inflation are now small but that has been so now for at least a decade and a half; this has not stopped very large swings in the exchange rate due to these other reasons which affect the ? real exchange rate’ (that is, the exchange rate adjusted for relative inflation. )

The problem then for the UK is that if they join the Euro they thereby increase their exchange risk against the dollar as the Euro swings around against it. If they remain outside, the pound can as these swings occur ? go between’ the two, rather like someone sitting on the middle of a seesaw. The chart of the UK’s own effective (or average) exchange rate – Figure 2 – juxtaposed against the Euro/dollar exchange rate shows rather clearly that we have been able to enjoy less volatility in our overall exchange rate by tying to neither of these two big regional currencies. To start, I will discuss the arguments against the UK joining the Euro.

The UK government has 3 major macro economic objectives and 2 on a slightly smaller scale: i) a high, but stable rate of economic growth within the UK’s potential ii) high, but stable employment iii) low inflation iv) balance of payments equilibrium and v) fair and equal distribution of income. In order to balance these objectives, governments use policies to control various aspects of the economy, however, in the analysis that follows, it will be shown that the most important of these policies, Monetary policy, would be rendered unusable to control the UK economy should the single currency be adopted and others will be curtailed.

The monetary policy today is used to control inflation, because low and stable inflation is the best background to achieve economic growth in terms of real GDP. Fig 3 shows a shift to the left of the Aggregate Demand (AD) curve caused by a rise in interest rates, this leads to a lower equilibrium price level. Loosening monetary policy by lowering interest rates shifts the AD curve to the right and leads to a higher equilibrium levels of prices (fig 4). In this situation, this would lower consumer expenditure since there would be a higher incentive to save and more costly to borrow.

This is useful because in the future should we find ourselves in the position of deflation the lowering of interest rates would help to rise prices and solve this so that the central symmetrical target of 2. 5% +/- 1%. Figure 3 Figure 4 Britain is currently enjoying a period of stable growth of 2. 25%, which has been achieved by being able to change its policies appropriate to her circumstances. As with ERM membership in 1990-2, a major concern of some economists is that membership of the euro would deprive the UK of an independent Monetary Policy.

The introduction of the Euro could make this policy unstable because interest rates for the Euro-zone members are set by the European Central Bank (ECB) and is the same for all member countries. Of course, the ECB is able to operate monetary policy over the whole Euro-zone, but an increase or decrease in AD might have a positive effect on one economy but a negative one on another. And the requirement of complying with the stability and growth pact will remove their freedom to react to economic circumstances on a national level.

Economists argue whether the economies of the Euro-zone are suitably converged to allow policies such as this to be universally used. Besides, the British economy has a higher sensitivity to interest rate changes because of Britain’s higher proportion of mortgage owners; in particular, those with variable rate mortgages. Also, as with decimalization in 1971, converting to a new currency offers an opportunity to retailers to round up prices and take advantage of the confusion.

There are inherent differences between the British and Euro-zone economies. Its pattern of external trade links is still different, though progressively assimilating, and the transition mechanism joining the financial system to the real economy is also different. The British economy is invariably out of phase with other European countries, entering recession and recovery at different times to that of most of her EU partners and historically Britain has been more in-line with the US trade cycle. Figure 5: Business Cycle diagram-lack of convergence.

One important factor to note is that since the introduction of the Euro, Germany, which was once heralded as the model for future economies, continues to slip into abyss, while on the other hand Ireland is experiencing a boom. This only serves to prove that there have been problems with the Euro and convergence. This is one of Gordon Brown’s five economic tests, that the UK must converge with euro zone countries before joining the Euro, enabling the UK to be comfortable with Euro interest rates.

But it is fair to say that convergence may be temporary and that the UK could easily fall out of sink with the other countries. Fiscal policy is closely linked to monetary policy and is a major tool also used to control AD; however it does so by controlling the level of government spending and taxation. A rise in government spending, with the price level constant, will increase AD, pushing the AD curve to the right.

Equally, a cut in taxes will affect AD, such a cut could be on income tax or national insurance contribution, and this will lead to a rise in the level of disposable incomes to households. As households keep a greater proportion of their income in such a situation, this would lead to greater consumer spending and hence an increase in AD, shifting the AD curves to the right. Of course, both can be applied vice versa as well. There are no firm plans at the moment for the harmonization of taxes within the euro zone however; with the adoption of the Euro the fiscal policy is greatly limited.

One of the convergence criteria for joining the Euro-zone is low government debt especially in respect to achieving a required budget deficit figure of 3% GDP; hence, not enabling the domestic government to increase public spending as it would acquire debt. This also leads to the government’s second test. This is whether there is sufficient flexibility in the economy and it refers to how well the economy could cope with problems and how quickly the Euro system could act in order to deal with a setback.

Furthermore, the loss of competitive devaluations as an economic tool in respect to other European countries would further hinder a government’s ability to manage its own economy and we would also lose the capability to change our balance of payments. This power would be handed over to the ECB. This leaves only supply side policies, which are limited with regards to their applications. This would involve the deregulation to lower costs of business, and increasing labor productivity all effectively increasing growth rates.

The strength of the euro was supposed to be guaranteed by ensuring that the economies of all the participating countries were in a healthy state and had significantly converged at the time of joining by insisting that they met strict entrance criteria. In reality most of the countries failed to meet the stipulated targets (especially in respect to achieving the required budget deficit figure of 3% GDP) but with the exception of Greece (initially), were allowed to join anyway due to the fudging of the convergence criteria.

The subsequent poor performance of the euro on the international currency market could be an attribute this. In the short period after the launch of the euro, the euro fell against the pound. The pound was strong and this greatly affected the number of exports leaving the UK. This would affect the third test which is the euro’ impact on Foreign Direct Investment (FDI). The cost of a change over to the euro would have to be borne by all businesses in the UK, regardless of whether they trade with the Euro-zone countries or not.

It is likely that we would experience higher levels of unemployment following the inability to continue to match economic efficiency with the euro zone. It is important to note that a large majority of British companies, especially smaller ones, survive by selling to local markets. However, these firms would still incur the costs of conversion e. g. new accounting and payroll systems. I believe, the concept of greeter price transparency is a fallacy, since even if consumers become more aware of price differences they are still more likely to buy in their local high street rather than make the effort to buy from another country.

Price comparison is already straightforward; all that is required is a calculator. Also, one of the UK’s concerns is that countries such as Germany and France are not yet as deregulated as the UK especially in the Labor market. They do not hold a hire and fire policy, which again questions the flexibility within the euro system. In contrast, however, there are many advantages to the euro the first of these is that ultimately abstaining from the Euro means higher costs (as far as transaction costs are concerned) than if we joined.

The commissions involved in buying the Euro when trading with European countries will remain an uncertainty of rising from a floating exchange rate; it is likely that this could affect the number of UK exports being purchased by continental European countries. In short, UK exports will be more expensive to Euro-zone countries compared to exports of other Euro-zone countries due to the changing cost of buying the pound. Membership of the Euro-zone would eliminate these costs.

We would also gain greater price transparency, which would inevitably lead to greater allocative efficiency in the fact that we obtain greater freedom of information and in a sense, perfect competition. This would lead in the long-term to economic growth. The introduction of the euro will lead to the development of a truly a single European market resulting in improved competition between companies across the euro-zone area. This will ultimately lead to leaner, more competitive industries and to lower prices and better value for consumers.

By joining the single currency British businesses will enjoy the benefit of a fixed exchange rate with Britain’s biggest single trading partner i. e. the Euro-zone. The benefit of a fixed exchange rate is that it provides companies with the ability to plan and budget for future activity and expansion since the value of a transaction will not have changed due to currency fluctuations during the time that elapses between the signing of a deal and the receipt of payment.

At present, a British company selling goods or services to a Euro-zone customer runs the risk of eventually receiving payment in a currency, which has subsequently devalued against the pound. The euro makes it possible to more accurately predict the future costs of producing goods in the UK for European markets by removing the factor of a potentially volatile exchange rate between the pound and the euro. The removal of separate national currencies across Europe will increase pressure on uncompetitive businesses to become more efficient.

This would occur as cross-border investment will be more likely as apposed to the traditional reluctance of many investors to move their money into a currency other than their own, meaning that the level of investment received by a company would based on their competitiveness rather than their nationality. Additionally cross-border mergers and acquisitions will also lead to more streamlined and efficient businesses across the Euro-zone. Tourism and tourists as in industry would also benefit from the introduction of the euro.

This would occur as holidaymakers and travelers would no longer incur the costs of currency conversion when traveling between Britain and other euro countries. Notes and coins issued in the UK would be legal tender in Europe, moreover, money which is not spent on holiday could be spent back in Britain, thus helping to reduce the amount of money leaving the country, thus benefiting our domestic economy as shown below in the circular flow of income cycle.

There are also two other economic tests put forward by Blair government: The impact of the Euro on financial services-This refers to how large corporations will benefit or not from joining the Euro. The lack of speculation on exchange rate could create stagnation. However, on the other hand, the new ease with which foreigners within the Euro zone could invest in UK corporations could benefit the stock exchange. A particular factor that has to be taken into consideration is the strong international financial service industry based in the city, Edinborough and recently Leeds.

The last economic test is whether joining would be good for employment. Ultimately this would be true as the larger labor market would, in theory, increase competition and the number of jobs and hopefully increase demand. This would therefore increase the number of jobs and lower unemployment. In addition, if Britain abstained from the Euro for a long amount of time then businesses could move towards Europe for its workers (due to the larger labor market and the removal of transaction costs).

This could lower the number of jobs in Britain and cause higher unemployment. Ultimately a single currency goes one step further to the completion of the Single European Market, by opening up the markets of each member and linking them with one currency. Labor markets are also linked and the economies of the euro-zone can become more synchronized, lending themselves to full integration. One major advantage to the Single European Market is that it would be a competitor to the USA on a global scale. This would serve a few functions, which may benefit the UK.

Firstly, at present, economies of the world follow the movement of the US stock market (namely the S&P and Dow Jones), should the Single European Market be a success then it may mean that should the US suffer a recession then the member countries wouldn’t be as adversely affected. The aim is to clarify the economic issues as even- handedly as possible. There are of course both pros and cons. But at bottom they are both quite simple. Better living standards If the UK joins, they shall over time achieve higher living standards.

This is because they shall be full members of a huge single market, which can achieve the economies of scale and competitive excellence that a single currency has made possible in the US. From our greater wealth they shall be able to pay for the better hospitals, schools, houses and railways that we all aspire to. The mechanism is quite straightforward. Separate currencies, fluctuating against each other, are a real barrier to trade and thus to efficient levels of production. If a company produces output in Britain, it currently pays its workers in pounds.

It can then sell its output on the Continent in return for euros. But unless it knows in advance how many pounds it will receive for each euro, it has no idea how profitable it will be to trade in Europe. On past experience the pound can easily and quickly rise or fall by 20% against the euro, with a massive impact on profitability. This ? exchange-rate risk’ discourages trade, and thus reduces productivity and living standards. This very same exchange-rate risk used to exist between countries on the Continent, discouraging trade between them as well.

But, since January 1999 when the euro was established, this risk has been eliminated for them. The result has been a truly remarkable 20% increase in trade between euro-zone countries (relative to GDP). By contrast trade between Britain and the Continent has fallen (relative to GDP). The table tells the tale. In just three years since the euro was launched the average euro-country expanded its involvement in European trade by one- fifth, while the UK reduced theirs. Trade with other EU countries, as % of GDP FranceGermanyBritain 1998282723 2001323223 Change+4 +5-1 As trade patterns change, so do investment patterns.

Any business that wants to serve the large euro-zone market will now naturally move its production inside that area, in order to avoid exchange-rate risk. Since the euro began, Britain’s share of the foreign direct investment coming into Europe has fallen from one half to one quarter ? an astonishing collapse. Last year more of this investment went to the Netherlands than to Britain. Meanwhile, inside the euro-zone a massive reorganization of productive investment is underway. The amount of direct investment flowing between the 12 euro-countries is up by a factor of four.

In this great process of restructuring, we shall be increasingly on the sidelines. For we are now in a new, more exposed position than before the euro was launched, since we are now the only large country in Europe where businesses face exchange-rate risk when selling on the Continent. This will have an increasing impact on our trade and thus on our productivity and living standards. Our productivity per hour worked is currently 20% below the level in France, Germany, the Benelux and Northern Italy. And investment in our economy is also lower relative to GDP.

If the UK wants the standard of hospitals, schools and railways that exists on the Continent, they may have to join the euro. Otherwise they risk growing more slowly than the rest of Europe, which is precisely what happened when they refused to join the Common Market after the Second World War. Economic fluctuations For better standards of living and better public services, they might need to join the euro. On the other hand, there is also the issue of economic fluctuations ? the extent to which unemployment varies in response to economic shocks.

Here there are both pros and cons to joining. At present the Bank of England tries to cushion shocks to the British economy by raising or lowering interest rates. If they joined the euro that would not be possible, since there would one interest rate for the whole of Europe. It would be set by the European Central Bank, on which all countries including ourselves would be represented. The UK view would be one among many. While the European Central Bank should protect us against shocks affecting the whole of Europe, it would not protect us against shocks that were particular to Britain.

Since they would have lost our own monetary policy to combat those shocks, it would be more difficult to offset them in the traditional manner. Yet it would not be impossible, since they would still be able to use the Budget to offset shocks to the economy. In this respect Britain would be better off than a US state when it is hit by a shock that does not affect the whole of the United States. For the typical US state is obliged to balance its budget year on year, including during a recession. This means that during a recession it has to raise taxes or cut spending, both of which are positively harmful.

This handicap is only partly offset by the automatic stabilizers provided to the state through the Federal US budget. By contrast the US state undoubtedly benefits from greater labor mobility than that between Britain and the Continent. But, all things considered, there is no reason why a single currency should not work at least as well for Britain as it does for any US state. Moreover, a single currency removes one major source of shocks – the floating exchange rate. A floating exchange rate is not a smooth mechanism of adjustment; it is more like an unguided missile.

In 1980/81 we saw its devastating effect on the British economy. As capital becomes ever more mobile, it is likely that exchange rates will become even more unstable. Good monetary policy can partially offset the effects of an errant exchange rate, as it has recently. But they cannot fully rely on it. Thus joining the euro has two effects on fluctuations: one bad (the loss of our interest rate) but the other good (the loss of our exchange rate). The overall balance facing voters is a clear gain in living standards versus mixed effects on economic fluctuations. I think the balance is strongly in favor of joining in some regards.

When and how? There remain the issues of when and how to join? Now is as good a time to join as any other that is likely to arise. The cyclical patterns in Britain and the euro-zone are extremely similar ? neither of them are far from their sustainable levels of output (relative to trend). Both have identical long-term interest rates. And short-term interest rates and inflation rates are not far apart. Moreover there is no case in favor of “wait and see”. For even if the UK waited a long time before joining, the next shock might not arise until after they had joined.

Meantime, by waiting they should have missed out on the great restructuring of the European economy and its trading patterns that is already underway. To join the euro, the Government has to recommend entry, and the British people have to vote for it in a referendum. In addition, they have to agree with the European partners the date of entry and the rate at which pounds will be converted into euros. This rate is therefore a political decision. Once markets know what the entry rate will be, the current market rate will move close to that level ?

depending on how likely is a successful outcome to the referendum. The exchange rate earlier this year was too high and made Britain less competitive than it needs to be. The typical view in business is that a suitable rate is between 1. 40 and 1. 50 euros to the pound. Other issues This summary covers what we believe to be the main economic considerations that should affect any voter’s decision in a referendum. However, many other economic issues have been brought in, which we must touch on. ? Is Europe the right partner? Over half our trade is with Europe and only 16% with the US.

The rest is spread around the globe. This pattern reflects the realities of geography. If we want to integrate into a large market, the only one available is in Europe. Joining NAFTA would make no sense and would require us to leave the European Union, at massive cost. ? Is Europe a ? failing’ economy? Critics argue that Europe is a failing economy. This is simply false. Productivity per hour of work is 20% higher in France, Germany and the Benelux than it is in Britain. Over the last 20 years it has grown faster there than in the US, and those Continental countries are now as productive as the US.

France, Germany, Italy and Spain have significantly higher unemployment than Britain. But six other European countries have lower unemployment rates than Britain or the US. So there is no single European problem with unemployment. The differences between countries are caused by different national labor market policies. If we join the euro, this would have no effect on the labor market policies we can choose in Britain. Nor does linking our currency to that of a high unemployment country like France mean that we ourselves would risk higher unemployment here.

The Netherlands has only one third the unemployment of Belgium. And within the single currency area of Britain, the South-East has one half the unemployment of the North-East. The link to the North has not increased unemployment in the South. High unemployment in some European countries is therefore no argument against joining the euro. And the argument that we should wait for the unemployment rates to converge is like saying that the South- East of England should have its own currency. ? Won’t the Euro require a federal budget?

In the US the states have to have balanced budgets while the federal budget helps a state that is in recession, by automatically collecting lower taxes and paying higher welfare benefits. By contrast, in Europe the automatic stabilizers are built into the national budgets, which can also practice discretionary stabilization policy. Therefore, no federal budget is needed in Europe to offset shocks. ? Won’t joining mean tax harmonization? Tax harmonization has nothing to do with the euro or the European Central Bank in Frankfurt. Tax issues are dealt with by the Council of Ministers when they meet in Brussels.

These issues currently require unanimity, as does any revision of this procedure. ? What about Europe’s ? unfunded pension liabilities? European governments currently spend more on pensions than Britain and will have to spend even more as population’s age ? unless they change their policies. However, this poses no threat to Britain because the Treaty explicitly forbids collective support of any country’s budget. And, in fact, the countries are likely to change their policies, raising retirement ages and lowering benefits, long before any crisis point is reached.

? What about our floating -rate mortgages? In Europe most house-buyers have fixed rate mortgages, while most Britons have floating rates. So it is said that our economy is more affected by changes in interest rates than those in Europe, making a one-size- fits-all interest rate more damaging. But higher interest rates benefit lenders at the same time as they hurt borrowers. The best econometric evidence concludes that the overall effect of interest rate changes on economic activity is similar in Britain and on the Continent. ? Won’t joining distract us from improving our social services? Far from it.

The whole purpose of joining is to achieve a higher standard of living. In France, Germany and Benelux, the hospitals, schools and transport systems are far better than our own. We can only achieve such standards if we can improve our efficiency, by becoming a full member of the European market. In 1957 we were the richest major country in Europe. But we decided to go it alone. In the years that followed, France, Germany and the Benelux overtook us. As the figure 6 shows, we are still trying to close the productivity gap that emerged then. If the UK fails to join the European leaders, they can risk falling further behind them.

Figure 6 There are of course pros and cons of joining the Euro. I have tried to set them out fairly and research both sides equally. To end, the UK economy is strong at the moment and has many prospects despite opting-out of the Euro for the moment. Capital inflow is likely to continue even if we stay out of the single currency and the UK still has attractive supply-side factors in both product and labor markets for foreign investors. Particularly, the UK will remain attractive for Far Eastern countries such as Japan and the so-called tiger economies. Although I have seen presented great points for both arguments, I believe that currently the risks outweigh the advantages that would be gained from joining the single currency.

As mentioned before, the UK economy is at its peak and is doing considerably better than other Euro zone members. If the UK joined the Euro then it is highly possible that the less fortunate countries will drag the UK down with them. Furthermore, the ECB will likely have to take relatively drastic action to keep some of the poorer economies in the Euro zone in check. This could have adverse effects on the otherwise sound economy of Britain.

The problem is that the economies of the Euro zone are not suitably synchronized to allow economic control to be universal over all of them. Universal measures are the only option with a single currency. If Britain remains out of the euro zone for the time being until the single currency has had a chance to both synchronize and improve the economies of the Euro zone, then it might be in a better position to offer advantages that outweigh the risks. On the other hand, if the Euro fails miserably and its economies go into recession, then we will be suitably distant from it to avoid unnecessary damage to our own economy.

Inappropriate currency arrangements can certainly wreck an economy but paradoxically while a bad currency, such as the euro, reduces prosperity, a good currency does little directly to help an economy. In the long run, the economic health of a country is determined by fundamentals such as the rule of law, low taxes and good incentives to save and invest. UK membership of the euro could only get in the way and damage Britain’s current economic strength. EViews Analysis 1: Dependent Variable: LUKCPI1 Method: Least Squares Date: 06/25/07 Time: 03:00 Sample (adjusted): 19