Wednesday, January 14, 2009

Euro Benefits - Revisited

Back in 1999 - 2000 there was a great debate about whether UK should join the Euro. Ever since I started teaching Economics, I have been sceptical of the benefits and worried about the potential costs. (Why UK will never join Euro - written 2 years ago) However, with the collapse of the Icelandic Krona and strength of the Euro amidst great financial turmoil it is worth re-evaluating the case for joining the Euro to see whether UK would really benefit.

Firstly, what are the advantages of joining?

  • Strength in Numbers. It is no coincidence the Euro has been strong in a year of great financial turmoil. The Euro seems to be a sea of strength amidst collapsing currencies. Being in the Euro also seems to give greater strength to the Bond market (making it easier to finance national debt) as there is less fear of governments defaulting.
  • Greater confidence. The current turmoil shows the importance of confidence. Markets so far have faith in the low inflationary record and stability of the ECB.
  • Lower transaction costs for business
  • Price transparency - easier to compare costs and prices within Eurozone
  • Less exchange rate volatility - making it easier for firms to predict exchange rate costs. Especially beneficial for British tourists.

Problems of Euro.

Strength of Euro helps mask problems. Because markets have confidence in Euro markets it has arguably encouraged countries to persist with unsustainable deficits. For example, Italy has national debt of over 105% of GDP (roughly twice UK). Because it has been in the Euro, investors have been willing to buy Italian bonds at a lower interest rate than if Italy was not in the Euro. If Italy were not in the Euro they would have faced greater incentives to reduce their high deficit. The Euro doesn't alter the fact Italian debt looks worryingly high, especially with demographic factors making future forecasts look grim.

Strength of Euro is a mixed Blessing. A country like Germany relies on exports for growth. The strong Euro has helped push Germany into recession, even though they didn't have a housing / credit boom and bust. A falling Pound creates bad headlines and grumbles from expats living in France, but, a falling pound does offer some support to exporters in this recession.
  • It is worth remembering the experience of 1992, where it was only when UK left ERM and devalued pound that we were able to emerge from recession.
Common Monetary Policy The fact the ECB sets interest rates for the whole Eurozone is still a problem for UK. If the UK was in the Euro, interest rates would be higher. If the UK really did have a much deeper recession, we would like the flexibility to cut rates much more aggresively than in Euroland.

Poor Growth Record of Eurozone. For all the stability of the Euro, it has failed to stimulate economic growth in the Euroarea. GDP per head has remained at around 70% of the US. For several years, the UK was outpacing the Euro economy. Unemployment in the Eurozone has also remained persistently high

The problem is many people see the weakness of the Pound as a reason to join the Euro. But, this assumes the weakness of the Pound is damaging to the economy. The weak Pound isn't causing problems, it is just symptomatic of the economy's weakness.

As a frequent traveller to Europe, part of me would really quite like to have the Euro. But, from an economic perspective, I fear that joining the Euro would still be an unwelcome constraint on UK monetary policy and exchange rate.

Yes, the Euro experiment has proved many critics wrong and it definitely has some advantages. But, it is important not to get carried away, the eurozone area is really facing some testing times.
  • Housing busts in Ireland, Spain.
  • High deficits in Italy, Greece and Mediterranean
  • Recession in major Euro countries.
  • The next few months will be just as testing for Euroland as it will for US and UK.

1 comment:

Anonymous said...

If I'm not mistaken, Iraq had switched from the Dollar to Euro in trading. I think US' involvement to beat them back to their currency.

It would make sense yes? US, as a superpower, wanting to keep its Dollar as the attractive one?