Monday, May 18, 2009

At Least we Are Not in the Euro

How would the UK economy have fared if we had been in the Euro? Could we have avoided the current crisis or would it have been worse?

Firstly, if we had been in the Euro, UK interest rates would have been set by the ECB according to what was best for the 16 Eurozone members. It is possible if the UK had been in the Euro, the ECB would have pursued different interest policy, but I doubt it. With 16 members it is hard to set rates just to help one country.

Firstly, in the boom years, 2004-07 UK rates were higher than the ECB interest rates. If we had been in the Euro, we would have experienced lower interest rates during this period. ECB rates were 2% during 2004 and 2005. This could only have exaggerated the housing boom, encouraging even more to try and buy a house. House prices could have risen even further giving them further to fall when the market turned in 2007.

Secondly, after it become evident the UK was heading into a deep recession, UK rates fell much quicker than ECB rates. The cut in interest rates doesn't seem to have helped the UK economy that much. But, without the rapid rate cuts the UK recession would have been deeper.

Thirdly, in the Euro the UK would not have been able to pursue quantitative easing - increasing money supply to help avoid deflationary pressures.

Fourthly, we would have not benefited from a depreciation in the value of the Pound. This depreciation is helping to boost exports compared to Germany which is seeing a drastic fall in exports.

In many ways, this recession should have hit the UK the hardest in Europe.
  • The UK had the greatest exposure to a failing financial sector
  • The UK had one of the largest booms in house prices and the highest rate of homeownership
  • The UK had one of the highest levels of consumer debt and lowest saving ratios.

However, the data from the first quarter of the Eurozone show a quartely fall of 2.5% for the Eurozone ( annual rate of -6.4%). The ECB commission predict a nearly 5.4% fall for Germany and 4% for the Eurozone in 2009. BBC link

Some issues like the rapid rise in UK public sector borrowing wouldn't really be affected by being in the Euro. The UK economy is far from showing signs of any real recovery, but, the combination of aggressive policy shifts does seem to have averted a catostrophic fall in UK output that could have occured without radical policies.

Looking at the Eurozone fails to inspire any confidence in recovery. The ECB seem to have an institutional and irrational fear of inflation which is misplaced in the greatest recession since the 1930s.

It may be the weakness of the Eurozone will cause the Euro to fall. And this combined with a global recovery could help pull out the eurozone economies out of the deepest recession in living memory. But, it is far from a foregone conclusion. Evidence suggest that GDP in the Eurozone is only 3% higher than in 2000. Already people are talking of a lost decade and if deflation sets in like in Japan it will only get worse.

No comments: