UK Euro Membership: Macroeconomic Implications Analyzed

Introduction: Britain and the European Monetary Union

Britain joined the European Economic Community (EEC) in 1973, an institution later transformed into the European Union (EU). Today, the 500 million residents of the EU generate a 30% share of the nominal gross world product. The EU operates as a single market through a uniform legal system that fosters the free movement of people, goods, services, and capital, along with common policies on trade, agriculture, fisheries, and regional development. In 2002, 12 EU member states retired their own currencies in favor of the euro. Four more members have since adopted this common currency, constituting a 16-state "eurozone."

For complex reasons, the UK is not yet among them, although its stated policy has been to eventually join. The decision on membership of the single currency was to be based upon the national economic interest. The government committed to ensuring that the UK would retain a genuine option to join the single currency, if that is what the government, Parliament, and the people — in a referendum — decided.

Macroeconomic forecasts are used by governments and large corporations for the development and evaluation of economic policy and business strategies. The macroeconomic indicators influenced by such a decision include GDP, unemployment rates, and price indices. Macroeconomists develop models that explain the relationships between factors such as national income, output, consumption, unemployment, inflation, savings, investment, international trade, and international finance (Minford 2002).

On the one hand, Britain stood to lose political and economic influence by remaining outside the EU monetary system. HM Treasury's policy on membership of the single currency centered on a set of five tests first set out by Gordon Brown in 1999. The central question was whether the UK economy was converging with those of eurozone countries and whether this convergence could be sustained over the long term. The second test asked whether there was sufficient flexibility to cope with economic change. The remaining three tests assessed the impact of joining the euro on jobs, foreign investment, and the financial services industry (HM Treasury 2003).

So why the reluctance? The euro's performance over recent years had been poor as measured by its value against the pound and the US dollar, and by the relative performance of the European and UK/US economies. While a currency union can offer economic benefits under favorable conditions, the absence of independent exchange rates removes one of the most effective tools for adjusting imbalances between countries when their economies face hardship — as seen with Greece in 2010. History demonstrates that well-timed devaluations can pull an economy up, and many argued that the UK should retain this option (Garganas 2003).

HM Treasury's Five Economic Tests

It may also prove more difficult to sustain a currency union than to begin one. European Community tax revenue amounts to only 1.5% of gross domestic product — inadequate for an effective system of redistributive taxation. So long as the UK market experiences periods of inflation, a low European interest rate regime could prove damaging. With capital mobility, flexible exchange rate adjustments are unavailable to policymakers, and the more frequently such adjustments are needed, the less reliable a pegged exchange rate system becomes (Wesley 1999).

In policy analysis terms, the implication of the Mundell-Fleming model is that monetary policy and fiscal policy constitute two separate policy instruments. However, since government spending derives from taxation, borrowing, and/or money creation, any analysis of monetary policy must make consistent assumptions about fiscal policy. Under this view, monetary and fiscal policies are not independent of one another and must operate together within the EU. A workable exchange rate regime also depends upon fair dealing and trust between countries, the rule of law, respect for contracts, and a stable political system.

A single currency eliminates separate national monetary policies and required the creation of a new central bank — the European Central Bank (ECB) — to administer EMU monetary policy, particularly the setting of interest rates. For example, should Italy wish to combat unemployment through interest rate adjustments, it cannot act independently, as that authority rests solely with the ECB.

In favor of joining is the fact that the large eurozone would integrate national financial markets, leading to higher efficiency in the allocation of capital across Europe. The Treasury's official assessment of its five economic tests acknowledged that EMU membership for the UK could enhance productivity by increasing trade flows between the UK and other EU nations, boost investment, and stimulate competition in product markets (Artis 2000).

The Case for Euro Membership

EMU may help UK households through lower prices and higher wages. It may promote supply-side reforms in the EU, aid specialization, and enhance the UK's comparative advantage across a range of industries over time. Britain's flexible labor market would be highly effective inside a single currency area, yielding increased investment from outside the EU. Britain has been a major recipient of foreign direct investment in recent years. By removing currency obstacles and improving access to funding, EMU could also facilitate the development of UK-owned multinational enterprises.

Membership of the euro would assist consumers and businesses with price comparisons across EU countries, encourage cross-border trade, and increase free-market pressures. The monetary policy of a European-wide central bank would eventually render the euro a strong currency and thus permit lower interest rates than those prevailing within the UK — with investment and growth as obvious beneficial consequences (Wargitsch 2001).

Sustained low inflation, supported by an independent European Central Bank, would lower long-term interest rates and encourage sustained economic growth and competitiveness. The EMU would be more adaptable and consistent than the preexisting Exchange Rate Mechanism and should not suffer the speculative attacks on currency seen during the 1990s. A European central bank focused on economic conditions across the whole community would therefore pursue a less volatile interest rate policy than the Bank of England or other national central banks.

By contrast, the following are among the principal macroeconomic arguments put forward against membership:

Conclusion

It is readily apparent that there are significant and substantive macroeconomic implications to the UK's decision regarding the euro, whatever determination is made. The important matter is to evaluate and weigh these implications in advance, and to disseminate the issues carefully to the public so that any democratic decision is fully informed.