Mark Austen considers whether the UK economy has on balance benefited from being outside of the Euro Area in recent years.
The current crisis the Euro area is in suggests that it was prudent for the UK to remain outside the single currency for two main reasons.
Firstly, Britain has reaped the benefits of having a floating currency free of the euro. In 2007 and 2008 the pound fell sharply against the euro, as a result of the weakening of the economy leading to a decrease in demand for the currency.
While this was a sign that Britain’s economy was in a bad state, it did have a number of benefits – the fall in the pound limited the effect of the recession on the trade deficit, thus reducing the scale of the crisis. Having a floating currency reduced the extent of the crisis, because as the economy shrank, the pound fell further, thus reducing the impact on trade and so lessening the rate of decline.
The situation in Europe was very different. Bubbles created by the introduction of the single currency led to higher costs and hence uncompetitive manufacturing in fringe countries (particularly Greece, Portugal, Italy, Ireland and Spain); when the recession hit and these bubbles burst, these countries saw large increases to their trade deficits.
If they were not attached to the single currency, a devaluation could have occurred which would have enabled this trade deficit to be reduced, easing the external shock of the crisis.
Secondly, because it is not governed by the European Central Bank (ECB), Britain is free to set its own interest rates.
The advantage here is again made clear by the contrast with the situation in Europe. Seventeen countries use the euro. Optimal currency area theory holds that for a single currency to work, responses to policy must be similar; otherwise, the benefits from policy decisions will be asymmetric, meaning any policy is a compromise.
Given the major differences in the composition of economies such as Germany and Slovakia, it is evident that the latter is true. As a result, the Euro zone is limited by the fact that it is unable to set an interest rate that benefits all countries.
Ideally, for example, one country might wish to raise interest rates to curb inflation (provided it has achieved a reasonable level of growth), while a country such as Greece might wish to cut interest rates in order to promote growth. Given the single base rate, neither can adequately achieve its goal. Instead, a compromise must be reached that is unable to maximise the benefit to either.
Differences in housing patterns, for example, can have a major impact on the effects of interest rates – home ownership in Germany is nearly half that of Greece, as a percentage of the population. This means the nature of people’s wealth is different, and so changes to interest rates will have an asymmetric effect. Britain, being one nation with an independent interest rate, can avoid these considerable issues.
Despite these potential benefits, being outside the single currency area is not without its costs. Having a separate currency potentially harms producers for two reasons.
Firstly, the floating exchange rate creates considerable uncertainty. If the only thing that is certain is that the exchange rate will vary, exporting firms have no way of predicting future revenues. This can harm trade, because it makes expansion risky: a producer might believe revenues will stay constant and so invests in order to expand production, but if the exchange rates rise and his goods appear more expensive overseas, revenues may fall, making it harder to earn enough to continue pay back the costs of investing.
Given this volatility, producers might be cautious about expanding.
Secondly, the exchange rate reduces price transparency. This affects both producers and consumers. Because prices must be converted, producers and consumers must spend more time if they wish to look abroad for better prices. As such, there is likely to be a proportion of the population who do not receive the best prices, because they value this time above the potential price saving. This reduces economic welfare.
However, the effects of both these factors are limited. Currency volatility, while existent, is a factor that must be considered for all trade – Europe is not the only destination for British exports (though it is one of the main ones).
Further, the pound is not currently proving to be particularly volatile against the euro: it is rising, but in a fairly predictable fashion. Given the sudden and largely unforeseen weakening that occurred in 2007, producers must be aware that an element of risk exists, but this awareness is unlikely to have a major effect on trade.
Secondly, although the lack of price transparency does have some effect on welfare, this is not necessarily an issue that would be resolved if Britain were inside the single currency, because of the differing prices within euro countries. Even though it is much easier to compare these prices, there would still be a cost involved with comparison given the disparities – the welfare loss would reduce, but would not be eradicated.
Being outside the Euro zone is also potentially costly for Britain because of the expense of changing currencies. These transaction costs can be considerable, costing up to 0.4% of GDP (according to a 1990 study by the EU).
The main disadvantage of this is that it deters foreign investment into Britain. If investors have to spend extra money converting euros to pounds in order to invest, this evidently reduces the likelihood of foreign direct investment entering the country.
Furthermore, transactions costs are likely to reduce trade, because if the cost of buying foreign imports rises, fewer will be bought. This effect may also decrease investment into the UK because foreign investment from outside Europe is more likely to be directed towards the Euro zone, because the lack of internal transaction costs make this a more attractive area to produce in. A factory in Germany has access to resources from any of the sixteen other countries in that use the euro without having to deal with transaction costs, whereas a factory in Britain will see its costs rise if it must import from these countries. As such, significant transaction costs could harm both trade and investment.
However, the scale of transaction costs may be in reality quite small. Since the EU’s 1990 report, digital systems have become far more widespread – the cost of transferring between currencies digitally is zero, because no extra vendor must be employed. For this reason, Britain’s more developed banking sector had already reduced its transaction costs to well below the average in 1990. As a result, it seems likely that transaction costs between Britain and Europe are now minimal. This is supported by the fact that the net inflows of foreign investment the UK receives exceed that of many countries using the euro, particularly since 2007. As such, it seems that the effect of transaction costs is minimal.
Overall, the United Kingdom seems to have benefited from remaining outside the Single Currency Area. Initially, the government’s fears about the euro were not realised, but the advantages of having a free and independent policy system – both fiscal and monetary – as well as a floating exchange rate have been seen particularly in the last five years since the economic crisis. Britain has gained considerably from these attributes, and these benefits do seem to outweigh the costs.
Mark Austen
Below is data taken from 2003, when the UK decided to opt out of becoming a full Eorozone member....
Evaluating the UK’s macro performance outside of the Euro Zone
- Decision made in 2003 that the UK would remain outside of the single currency
- UK remains a full member of the single market
- Supportive of further EU enlargement but distanced from deeper fiscal / banking intregration
Crucial question both in the short and medium term is whether non-participation in the Euro makes a significant difference to key macro outcomes
- Real GDP growth, estimated Trend growth (LRAS)
- Core CPI inflation and inflation expectations
- Employment and unemployment rates
- Trade balances (with EU and beyond)
- Trends in relative productivity and per capita incomes
Life Outside of the Euro – Evaluation
1. Economy boosted by depreciation of sterling 2007-09 – benefit of having a floating exchange rate, improvement in competitiveness, possible re-balancing of C+I+G+X-M. Struggling countries inside Euro Area do not have this option, rely more on structural reforms and internal devaluation (e.g. lower wages) to improve competitiveness.
- a. But impact of weaker sterling limited by external factors and financial fragility
- b. UK growth has been weak, output well below the 2008 peak, triple-dip
- c. Cost too of higher inflation in the UK – has averaged 3% since 2008 – cutting real incomes
- d. Floating exchange rate might be a factor limiting FDI in the medium term e.g. non-EU TNCs choosing Euro members as base for their EU FDI projects
2. Autonomy for the Bank of England to set policy rates at levels appropriate to domestic problems e.g. quicker reaction than the ECB to the financial crisis, freedom to introduce and expand the QE programme, and latterly the Funding for Lending scheme. Real interest rates negative, helping to avoid a depression. Flexible interpretation of the inflation target
- a. Criticisms of the Bank’s record, too lax on CPI inflation, QE storing up problems, unintended consequences of ultra-low interest rates including rising inequality
- b. ECB cut policy rates too, monetary policy environment similar to the UK
3. UK government able to ignore fiscal stability rules of being inside the Euro – has run larger budget deficits – Keynesian fiscal stimulus to boost demand. 10 year bond yields remain at historic lows, FP has helped to stabilise demand. UK less exposed to covering the cost of bail-outs. Emergency funding for countries such as Greece and Ireland.
- a. AAA bond rating has little to do with being outside of the Euro
- b. UK unable to avoid fiscal austerity, damaging to growth – may last longer than members of Euro Area
- c. UK banks and trading sector remains heavily exposed to Euro crisis even if outside of the currency bloc – there are mutual benefits from the Euro project working – risks of disorderly default are hug
Longer term issues
- UK perhaps missing out on some FDI inflows into the EU (strong competition from new EU entrants including some who have joined the Euro), gains from a single currency (lower transactions costs accrue every year – they are not one-offs).
- Being outside the Euro did not prevent the asset price bubble and bust in 2007-2010
- It is possible to be a member of the Euro and enjoy sustained growth and rising prosperity – Germany, Holland etc
- Easy to make contrasts with struggling countries such as Greece, Spain - but the UK is a different economy in many ways
- The Euro Area is far from being an optimal currency area – the risks of Euro participation rise because of the lack of real convergence between participating nations
