Tuesday, September 20, 2011

UK and Euro Crisis

Readers Question: If the UK had been in the Euro, would the Euro crisis have been worse?

Yes. After the credit crunch. The UK was one of the hardest hit economies.
The financial sector is an important element of the UK economy. The decline in financial output caused the UK to have one of the deepest recessions in the global economy (-6% in 2009). If the UK had been in the Euro, the UK recession would have been deeper. This is because:
  1. We wouldn't have cut interest rates so quickly.
  2. We wouldn't have pursued quantitative easing
  3. We couldn't have benefited from a 20% devaluation in the Pound.
  4. There would have been more pressure on UK to reduce government borrowing because of fears over liquidity shortage in Euro.
Given the scale of financial bailouts to UK banking sector and the fact the UK had one of the largest budget deficits in the EU, bond markets would have been very worried about the fiscal position of the UK government.


UK had one of largest primary budget deficits in EU | Source: Eurostat 2011

Outside the Euro, the UK can pursue its own monetary policy. The Bank of England can and has created money to buy UK government bonds. If the UK faces a liquidity shortage the Bank of England can intervene and calm market jitters. Markets don't fear a liquidity shortage in the UK

However, in the Euro, the Bank of England couldn't have solved a liquidity shortage. We would have needed to rely on ECB intervention. But, the ECB are much more reluctant to buy government bonds.

Therefore, in the UK could easily have faced a liquidity shortage and struggled to sell enough government bonds at certain times. This liquidity shortage and fears over liquidity would have led investors to sell their UK bonds leading to higher interest rates on UK debt. The UK would have faced a similar situation that Ireland and Italy are facing - rising interest rates and calls for more austerity to bring government borrowing under immediate control.

UK bond yields stay low, despite high government borrowing | Source: ECB long term government bond yields

The UK would have had to cut spending and increase taxes by even more than the current government plans. However, these austerity measures would have pushed the fragile UK economy back further into recession. Output would have been even lower and unemployment even higher.

Remember, in the Euro, the UK would not have had a 20% devaluation in pound or quantitative easing - which helped minimise depth of recession. In the Euro, it is hard to avoid the conclusion, the economy would have had lower GDP and higher unemployment - which means a bigger budget deficit and therefore more difficult to reduce debt / GDP ratio. market nerves

If the UK had been in the Euro, the Euro would have been under even greater strain. It would be another huge economy to support. UK government dwarfs Greece debt. If the UK had been in the Euro, it would have made fiscal support to struggling economies even more difficult for the EU and ECB.

By staying out of the Euro,
  • The UK has been able to benefit from lower interest rates on government debt. Markets at least don't fear a liquidity shortage in the UK that Euro countries face. We have less pressure to bring short term borrowing under control
  • The UK economy has more flexibility. The UK is not stuck in this negative spiral of fiscal austerity with nothing else to boost demand.
The UK had more room for manoeuvre than the coalition government let on. With interest rates low, the government should have targeted growth before short term fiscal austerity, which unfortunately has sniffed out the fragile recovery.

If the UK had been in the Euro
  • The UK recession would have been much deeper,
  • We would have a really serious fiscal crisis and higher interest rates
  • The Euro, and EU economy would be under much greater strain because they would have to deal with high UK debt.
Of course, some may say it would not be like this, but I really can't imagine how it could be any different.

A key issue is the fact membership of a single currency means you lose independent monetary policy. In difficult times, it leads to much higher interest rates on government debt. (problems of monetary union in recession)


1 comment:

Virtual Gent said...

If the markets decide the UK is not such a safe haven and bond yields rise will pension funds heavily weighted in Gilts tend to fall?