Should the UK Join the European Monetary Union? Pros and Cons

Introduction: The European Monetary System and EMU

The launch of the EMS, or European Monetary System, on December 5, 1978, was projected to accomplish monetary stability and foster convergence and cooperation of economic performance and policies between member countries. The EMS became operational from March 13, 1979, and consisted of four areas: the ECU (European Currency Unit), the EMCF (European Monetary Cooperation Fund), the VSTF (Very Short-term Financing Facility), and the ERM (Exchange Rate Mechanism). In 1992, the member countries approved the Treaty on European Union and adopted the EMU — European Monetary Union — and a single currency. However, the UK walked out of the ERM that very year due to currency problems, despite remaining a member of the European Union. The debate over whether the UK should join the EMU has since become a prominent topic of discussion both within and outside the country. (Roney; Budd, 1998, p. 95)

Arguments Against the UK Joining the EMU

There are a number of factors that would work against the UK's interests if it joins the EMU. According to an IMF study published in 2000, the UK currency was overvalued relative to the euro, and the IMF therefore recommended that the UK should not join the EMU or implement a single European currency, at least in the near term. (Harris, 2001, p. 362)

(i) Political situation: The UK government felt that the country's economy was not prepared to accept the transition to a single currency. (Harris, 2001, p. 362) The UK government believed that the EMU would operate in an inflexible manner that would pose a risk to the UK's economy, which had a high tendency toward inflation, and would also result in a weakening of its competitiveness. The Conservative government led by Margaret Thatcher also opposed UK membership of the EMU because it wanted to introduce a monetary policy effective at bringing down inflation. The argument was that if the tools of monetary policy — including interest rates — were focused on lowering the growth rate of money supply, it would not be possible to simultaneously direct those tools toward the exchange rate. The then-current UK government gave this issue serious consideration in 2003, but the tests against which it was evaluated — Gordon Brown's five economic tests — produced a result unfavorable to UK entry in the EMU. The government, however, vowed to reconsider the question. (El-Agraa, 2007, p. 223)

(ii) Lack of public support: A large section of the public remained indifferent to the EU, despite the fact that around 46% of Britons felt the European Parliament would become far more important to them than the British Parliament by 2020. Much of this public indifference stemmed from ignorance about the real benefits of joining the union. Only a very small proportion of the population had had any direct contact with EU activities, and the fishing and agricultural communities had actually been frustrated by EU actions. (Pilkington, 2001, p. 194)

(iii) Size and diversity of the European Union: Different countries have different types of economies that may not be consistent with the implementation of a single currency. For instance, the accession of Eastern European countries created problems, as differences in their economic systems made the euro more difficult to manage. (Harris, 2001, p. 365)

(iv) Risk of losing independent economic decision-making: Monetary policy and interest rates would be set by an unelected body rather than by the UK government. Interest rates would be determined with the aim of achieving price stability as stipulated in the Maastricht Treaty. Moreover, interest rates fixed on a "one size fits all" basis might not be appropriate for all nations. In the event of an asymmetric shock, an individual nation might not be able to implement a monetary policy suited to its own circumstances. The EMU would set inflation targets rather than the UK government doing so. (Harris, 2001, p. 365)

The structural rigidities present in European labor markets may affect the UK as well. Britain would also lose the ability to devalue sterling in order to maintain the competitiveness of its products during recession. The presence of a downward trade multiplier in the common currency area would hamper efforts at competitive devaluation. (Harris, 2001, p. 366) A monetary union means that the authority to set interest rates is assigned to a common central bank capable of setting only one rate. It is virtually impossible to fine-tune interest rates to suit the different economic requirements of individual countries. The only way out of this predicament is to ensure that member states possess the necessary instruments to tackle asymmetric developments. Labor market flexibility and reform can therefore provide member nations with the tools needed to adjust to asymmetric shocks. (De Grauwe, 2007, p. 101)

(v) Following the American example: A common currency operates across the various states of the US, where unemployed people are free to seek work in other states or claim federal benefits during periods of recession. However, this model would be difficult for the UK to adopt because of the vast diversity in language and culture and the absence of a central system capable of providing benefits or support. Moreover, the present EU budget is small, and any attempts to expand it would have an impact on fiscal autonomy. (Harris, 2001, p. 367)

(vi) Social, employment, and agricultural policies: The Common Agricultural Policy of the EU has already caused significant damage to the British farming industry. The entry of peasant economies such as Poland and other Eastern European countries has placed additional demands on the CAP, which could further deteriorate the situation in the UK and result in irreparable damage. Common employment and social policies enforced by the EU have the potential to damage UK market competitiveness and may obstruct its recovery from recession. From an industrial perspective, joining the EMU could compromise the UK's progress, development, and efficiency. (Pilkington, 2001, p. 198)

(vii) Domination by some countries: Where there are divergent inflation expectations among member states, some countries may exert undue influence over the operations of the Central Bank and its monetary policies. (What are the arguments for and against joining the Euro)

(viii) Sensitivity to interest rate changes: The United Kingdom is believed to be more susceptible to changes in interest rates than other EU nations. This may be partly due to the high level of owner-occupation with variable-rate mortgages in Britain's housing sector. The European Monetary Union has no monetary flexibility, and joining it would require the UK to introduce greater flexibility in both the labor and housing sectors. However, the rented sector in the UK is not large enough to function as a flexible alternative to owner-occupation. The UK had managed to address this problem effectively by establishing an efficient mechanism for controlling interest rates at the Bank of England. Joining the EMU would eliminate this policy lever while simultaneously removing the prospect of exchange rate policy. (What are the arguments for and against joining the Euro)

(ix) Structural economic differences: The European Regional Policy's agenda for reducing structural economic disparities between poorer members of the Union might require significant fiscal transfers. This could be harmful to the UK, which would not be able to afford large fiscal transfers within Europe. (What are the arguments for and against joining the Euro)

(x) Foreign Direct Investment: The UK attracts significant FDI, particularly from the US. FDI decisions usually serve both strategic and microeconomic purposes, involving considerations such as unimpeded market access, labor productivity, labor quality, and transportation costs. A US company would typically prefer to invest in a cheaper option available in the UK rather than negotiate access through a "fortress EU." However, this advantage is contingent on the stability of the pound relative to the euro. (Minford; Walters, 2004, p. 306)

(xi) Benefits of the pound: Sterling provides a profitable means of diversifying investment portfolios. Portfolio managers and global investors would be disadvantaged if the pound were to become obsolete, as opportunities for risk diversification would decrease significantly. (Minford; Walters, 2004, p. 306)

(xii) Competition to the US dollar: Were the UK to join the EMU and adopt the single currency, the threat posed by the euro — the only international competitor to the US dollar — would become real. The US would therefore be unlikely to encourage such a move, as it would represent a challenge to the dollar's standing as the pre-eminent international currency. (Minford; Walters, 2004, p. 306)

However, not all economic considerations work against the UK joining the currency union. There are several factors that could benefit the UK if it joins the EMU.

Conclusion

A transition period is always accompanied by difficulties, and limiting one's vision to the losses experienced during this period would be short-sighted. The UK government must be far-sighted enough to look beyond the transition period and consider the long-term benefits of joining the currency union. The EU and the EMU are still in their developmental phases and will need time to evolve into a more mature union. The problems associated with the EMU — a common interest rate, intra-European fiscal transfers, the UK's susceptibility to recurring bouts of inflation, and similar concerns — can all be worked around and must be given sufficient time to improve.

The fear that the nation might lose its political identity seems overstated in the modern world. It is true that there may be short-term costs associated with joining the currency union, but the long-term benefits may far outstrip them. Nevertheless, it would not be wise to rush into the monetary union at a time when the world is facing one of its worst economic crises. The UK must wait for the appropriate moment when joining the European Monetary Union would best serve the country's economic, political, and social interests.

References

De Grauwe, Paul. 2007. Economics of Monetary Union. Oxford University Press.

El-Agraa, A.M. 2007. The European Union. Cambridge University Press.

Harris, Neil. 2001. Business Economics. Butterworth-Heinemann.

Mankiw, N. Gregory; Taylor, Mark P. 2006. Economics. Cengage Learning EMEA.

Minford, Patrick; Walters, Alan Arthur. 2004. Money Matters. Edward Elgar Publishing.

N.A. n.d. European Monetary Union: Should Britain join the single European currency? A2 Module 6: Program of study 4: European Monetary Union. [Online].

N.A. n.d. Should the UK join the European Monetary Union? [Online].

N.A. 2009. What are the arguments for and against joining the Euro. [Online].

Pilkington, Colin. 2001. Britain in the European Union Today. Manchester University Press.

Roney, Alex; Budd, Stanley A. 1998. The European Union. Kogan Page Publishers.