The European Experience: Is Currency

Unification The Right Choice?

Abstract:
This article attempts to bring together the principle
arguments against a common currency in Europe. It is
argued that the prime obstacles for the success of the
euro are the inherent inflexibilities of any conceivable
single market in Europe.

Introduction:
The Eurozone is an attempt to bring about closer
coordination of monetary policies and greater mutual
exchange rate stability among the European nations.
Several factors had motivated the birth of the euro, a
prominent reason being to enhance Europe’s role in the
world monetary system, and to turn the EU into a truly
unified market.
In this article we propose to concentrate on the demerits
of adopting the euro by first reviewing some differences
in the macroeconomic performance of member countries
since the adoption of the euro in 1999.Then as a case
study we include the British reluctance to join the single
currency in the first round.

Does One Size Fit All?

To ensure sufficient degree of monetary convergence
among the member countries the 1992 Maastricht Treaty
required that any country joining the EU have an inflation
rate no more than 1.5% above the three best performing
member states. Nominal long term interest rates were
stipulated to be no more than 2% above the three best
performing member states. In addition, in recognition of
the dangers posed by fiscal instabilities to monetary
policy, it was further stipulated that annual budget
deficit be no more than 3% of GDP while accumulated
public debt be no more than 60% of GDP [Lane, 2006].
It came as a surprise that inspite of enforcing these rules,
the inflation differentials among the member countries
have been relatively large. Calculations on the basis of
Eurostat data have shown that over 1999-2004 the
inflation rates have varied from 1.5% in Germany to 5.6%
in Ireland [Lane, 2006].
Ireland’s experience calls for special attention: Irish
inflation, which was below 5% for almost 15 years and
averaging just fewer than 2% per annum in the five years
prior to EMU membership, suddenly accelerated in late
1999 and has since then been persistently at the top of
the EMU inflation league. CPI touched an annual rate of
7% in the twelve months to November 2000.[Honohan et
al., 2003].

CHART 0.0[A few countries outside the EU have

been included for comparison] Source: IMF

[Honohan et al., 2003] have argued that by removing an

effective instrument of policy restraint, namely,
exchange rate adjustments, the EMU itself has
contributed to the surge in Irish inflation. Furthermore,
by lowering nominal and real interest rates, the EMU has
further added an important demand fillip which
manifests as an increase in housing prices.
The points which have been highlighted heretofore
would have convinced the reader of the divergent
economic performance of countries within the EU
especially after the adoption of the Euro. It is a matter of
fact that the composition of factors of production as well
as raw materials in Europe is highly heterogeneous. It
also becomes obvious that different countries have
different sensitivities to shifts in euro exchange rates.
Hence these differences suggest that any attempt at
enforcing a ‘one size fits all’ monetary policy would only
result in a degradation of the performance of the
member states as in the case of Ireland.

Cross Border Labour Mobility:

The cost of changing to a new currency is less if labour
and product markets are sufficiently flexible. High
flexibility increases the capacity of the economy to
respond to external as well as internal shocks. The main
obstacles to labour mobility in the EU are language and
cultural differences together with uncoordinated pension
and entitlement systems [Lane, 2006].
It is also not clear whether monetary union has
promoted greater flexibility in real wages [Calmfors,
2001]. National wage setters must now take into account
the increased chances of loss of competitiveness due to
excessive and inflexible labour costs under the euro.

Global Competition:
Demands have been raised in favour of protectionism in
labour and product markets in view of the increased
global competition which have led to some reforms. But
a number of authors [Duval et al., 2005] have found that
the speed of the reform process has slowed down in the
area due to the opposition from key member countries.
While some loss in momentum can be attributed to
political obstacles, many authors have found that the
euro may be partly responsible [Saint-Paul, 2004; Duval
et al.,2005]. When a country has a single independent
currency, it would enjoy low interest rates on
undertaking structural reforms since the central bank
would accommodate an increase in potential output of
the economy. However, with a single European currency,
the EMU would target area wide conditions and would
only partially respond to reforms in individual member
countries. This reduces the incentives to the individual
countries to undertake reforms.
Hence we can argue that the adoption of the Euro as the
common currency in the euro area has led to quite a few
problems. We have seen that the one size fits all policy
can work against a country due to removal of effective
policy restraints (e.g. Ireland).Cross border labour
mobility which is so crucial for the success of the union is
limited due to various factors within the union. Finally,
the adoption of the single currency reduces the
incentives of the member countries to undertake
structural reforms which are necessary to tackle global
competition.
Case Study: The British attitude toward the
single currency
As promised, we now take up the issue of Britain opting
out of the Maastricht Treaty.
A number of authors have attempted to provide an
explanation as to why an important European nation like
Britain was reluctant to join the single currency.
A particularly forceful argument based on identity politics
is given by [Risse et al., 1999]. Here the author avers that
there are as many reasons to join the single currency as
there are against joining and that actors’ perceived
material interests with regard to the euro are strongly
influenced by their visions of European political order.
This would explain the contrasting attitudes with regard
to the euro in, say France, and Britain.
Now, we will look into the benefits which are alleged to
accrue to Britain on joining the euro.

Transaction Costs:
It was averred that transaction costs are eliminated on
joining the single currency as this would save resources.
However, [Minford, 2004] argues on the basis of an EC
report (1990) that for countries with advanced banking
systems like the UK, the saving derived from single
currency is smaller than other countries. This is because
in a computerized banking system, the conversion of a
payment to other currencies essentially requires the
computer to perform an additional operation at very low
marginal cost.

Source: Minford, 2004

[Minford, 2004] further enumerates one-off transaction
costs of changing the currency, which include changing
the accounting machines, vending machines, and banking
high street machines.

Exchange Rate Risk:

Many supporters of Britain joining the euro have claimed
that exchange rate risks are eliminated on joining the
euro.
Using stochastic simulations, [Minford, 2001] has shown
that the variability of the real exchange rate rises slightly
under a monetary union as compared to flexible and
floating exchange rates. This means that if Britain sticks
to the pound, its dollar exchange rate would be only
slightly less variable as compared to joining the euro.
Hence, [Minford, 2004] concludes that there are good
theoretical reasons for doubting the importance of
exchange risks affecting Britain.

Potential Costs to Britain on Joining the Euro:

The following potential costs have been enumerated to
accrue to Britain on joining the euro.
High Output Instability:
Since Britain trades so heavily with the world, Britain is
unable to respond to external shocks with its own
interest rate and is also destabilized by euro shocks
[Minford, 2004]. Also [Barrell, 2002] has found higher
output instability under the euro.

State Pension Crises:

In 1996 an OECD paper [Roseveare et al., 1996] projected
the three largest eurozone countries- Germany, France
and Italy- to reach respectively respectively 10, 8 and
11% (of GDP) state pension deficit. [Minford 2004] states
that conditions had worsened and that unemployment
was higher and growth slower than expected in 1997.
This illustrates another problem with adopting euro,
namely, the cost of meeting potentially explosive state
financial liabilities. The burden of meeting this would
ultimately be borne by the British taxpayer.

The Five Tests of Gordon Brown:

In view of the above problems with the euro, in 1997,
Her Majesty’s Treasury set five economic tests which the
euro has to pass before Britain contemplated joining the
eurozone. The then Officer of the Exchequer Gordon
Brown, set the following tests on the euro:
1)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)What impact would entry into EMU have on the
competitive position of the UK's financial services
industry, particularly the City's wholesale markets?
5) In summary, will joining EMU promote higher
growth, stability and a lasting increase in jobs?
[HM Treasury, 1997]

Assessing the tests:

In 1997, the treasury found that Britain was not
cyclically convergent with Europe. Base rates were
found to be 7% in Britain whereas they were just
above 3% in France and Germany [HM Treasury,
1997]. Flexibility was also not found to be sufficient
to meet the challenges of the EMU [HM Treasury,
1997].
Now, we look at the above statements in more
detail:

1) Cyclical Convergence:
“If the UK were to enter monetary union without
durable convergence, then the loss of domestic
monetary policy and lack of exchange rate
freedom could make the UK cycle more volatile.
This lack of stability would damage investment
and the underlying rate of growth and
employment would suffer” [HM Treasury, 1997].
Joining the monetary union would not by itself
trigger convergence, which would depend on
other factors.
Having suffered a recession in 1990s, there was
strong growth subsequently and unemployment
had also fallen down. However, growth in the
other European countries had been weaker. This
cyclical divergence did not appear likely to vanish.
The graph below clearly demonstrates how much
Britain was out of sync with Europe.

But the cyclical divergence implied above was by

no means unusual as the following graph
indicates:
 Source: HM Treasury 1997;
From the observations quoted above, Treasury
concluded that the UK cycle is not convergent
enough to commit joining the EMU in the first
round.

2)Flexibility:
For successful membership of the EMU the labour
and product markets must be sufficiently mobile
because as a member of the EMU, UK would lose
domestic control over monetary policy, and the
burden of adjustment would fall on the real sector
[HM Treasury, 1997].The flexibility can be
measured in terms of wage flexibility, employment
flexibility and employability.
 Treasury concluded that persistent long term
unemployment, together with a lack of skills
indicates insufficient flexibility to join the EU.
[HM Treasury, 1997].
The following chart indicates the standardized
unemployment rates in UK and a few EU
countries.

Source: HM Treasury, 1997

3)Investment:
For this point, Treasury observed that the UK
joining the EMU before it has achieved
 convergence and flexibility would not result in
encouraging prospects for investing in UK.

4)Impact on the City:

As in [Minford 2004], Treasury also enumerated
one-off disturbances on joining the EMU. Intra
Euro-area foreign exchange businesses would
suffer whereas extra Euro-area foreign exchange
businesses would thrive, particularly the City of
London. Thus Treasury did not predict any adverse
effects on the City by joining the Euro. In fact
Treasury stated that the benefits from the single
currency to the financial sector would be easier to
tap within the EMU [HM Treasury, 1997].

5)Employment and Growth:

Treasury noted that a successful monetary union
in Europe would result in a boost in investment
which would further result in stable growth and
increase in employment. Increase in intra-Euro
trade was also expected due to increased price
transparency and reduced transaction cost. But
still, the point remained that in order to actually
realize the benefits, sufficient convergence and
flexibility must be ensured.

Reforms:
Germany, in particular, was concerned about the
budgetary framework of the Maastricht Treaty. As
a result, the Growth and Stability Pact was
adopted in 1997. It led to the member countries to
aim for cyclically balanced budgets. The Pact has
been criticized for introducing even more
inflexibility within the eurozone [Grauwe, 2003].
This is because it has forced the member countries
to effectively drive their debt ratios to 0% which is
even more stringent than the Maastricht Criteria.
[Grauwe, 2003]. Hence it may be concluded that
the stability pact may also be a factor in
discouraging prospective new members from
joining. This is because issuing debt is a way of
ensuring inter-temporal cost sharing which is quite
effective in cutting costs. Hence forcing member
countries to further reduce debt ratios is
detrimental to production activites.
Conclusions:
From the discussions above, it is observed that
Britain has got much to lose from joining the Euro,
in the present scenario.
Arguments against the eurozone include a loss of
fiscal and monetary freedom which may act
against a country particularly in times of recession
when fiscal austerity may result in painful
consequences.
A one-size-fits-all policy may affect a country when
its business cycles are not convergent with the
continental cycles, as we have seen in case of
peripheral countries like Ireland.
The Five Economic Tests, although not part of
current government policies, have played an
important role in throwing into new light the
arguments for and against a single currency in
Europe.
Many authors [Grauwe, 2003] aver that the
Stability Pact is a major cause of all alleged
inflexibilities in the European market, and hence
any attempt at reform must concentrate on the
Growth and Stability Pact.
References:
1)Lane, Philip. 2006. The Real Effects of European
Monetary Union Journal of Economic
Perspectives 20(4): 47-66
2)Honohan, Patrick and Lane, Philip. 2003.
Divergent Inflation Rates in the EMU Economic
Policy 18(37): 357-394
3)Calmfors, Lars.2001. Wage and Wage Bargaining
Institutions in the EMU- A Survey of the Issues
Empirica 28(4): 325-351
4)Duval, Romain and Jorgen Elmeskov.2005. The
Effects of EMU on Structural Reforms in Labor
and Product Markets. OECD Economics
Department Working Paper No.438
5)Saint-Paul, Gilles.2004. Why are European
Countries Diverging in Their Unemployment
Experience? Journal Of Economic Perspectives
18(4) 49-68
6)Minford, Patrick.2004.Britain, The Euro, and The
Five Tests Cato Journal 24(1-2)
7)Minford, Patrick.2001. Tests 1 and 2: Flexibility
and the costs in Economic Variability In Bush:67-
78
8)Barrell, R.2002.The UK and EMU: Choosing the
Regime National Institute Economic Review 180:
54-71
9)Roseveare,D.; Leibfritz,W.; Fore, D.; and Wurzel,
E. Ageing Populations, Pension systems and
Government Budgets OECD Economic
Department Working Paper No. 168
10) Rise et al., To Euro Or Not To Euro
European Journal Of International Relations 5(2)
147-187
11) Brown, Gordon HM Treasury 1997
12) Grauwe, P. 2003. University Of Leuven