The launch of the Euro as a new currency in circulation in January 2002 marked a fundamental change in monetary arrangements for all members of the European Union. No country is immune to some of the static and dynamic effects of the creation of a single currency covering twelve of the fifteen member nations of the EU.

The European Central Bank

The ECB is in charge of setting a common interest rate for the twelve countries inside the Euro Zone (Slovenia joins the Euro as the 13th member in January 2007). The main policy objective is to achieve price stability – defined as “a year-on-year increase in the Harmonised Index of Consumer Prices of below 2%”. The British Monetary Policy Committee has a symmetrical inflation target – this is not the case with the ECB.

The ECB targets the growth of the broad money supply as a guide to the future direction of interest rates. Broad money is basically determined by the growth of bank deposits – the majority of which are created through bank loans and over-drafts. The ECB does not have an exchange rate target, although it has intervened on a few occasions to influence the external value of the Euro. The main differences between the ECB and the Bank of England are summarised in the table below:

A common currency requires a common interest rate. But arguments continue to rage as to whether the twelve countries within the Euro Zone stand to benefit from a ‘one-size fits all monetary policy’. Are they sufficiently similar (or convergent) in terms of economic performance for the benefits of Euro membership to outweigh the costs of having to accept a single rate of interest?

	European Central Bank	Bank of England
Location	Frankfurt	London
Goal	Price stability	Price stability
Chairman	Jean-Claude Trichet	Governor: Mervyn King
Inflation Target	Euro-Zone price inflation below 2% Inflation target is non-symmetrical	Consumer price inflation of 2% Permitted band of fluctuation = +/- 1%
Policy Tool	Euro Zone interest rate	Short term base interest rates
Voting	Votes split between countries who each have representation on the ECB Council	Nine member MPC   - meets monthly - one vote each – governor has casting vote

 

Joining the Euro – convergence criteria

Countries wishing to join the single currency must meet four convergence criteria.

1. Stable prices: Inflation must not be more than 1.5 percentage points higher than the average in the three member countries with best price stability, i.e. lowest inflation.
2. Stable exchange rate: The national currency must have been stable relative to other EU currencies for a period of two years prior to entry into the monetary union (ERMII entry).
3. Sound government finances:

1. Gross government debt must not exceed 60 per cent of GDP.
2. The annual government budget deficit must not be greater than 3 per cent of GDP.

1. Low interest rates: The 5-year government bond rate must not be more than 2 percentage points higher than in the three member countries where inflation is lowest.

The Case for UK Membership of the Euro

Trade, investment and productivity: The Treasury’s official assessment of its five economic tests published in June 2003 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. It could also help to promote supply-side reforms in the EU and encourage specialization and further exploitation of the UK’s comparative advantage in several sectors of the economy in the longer term.
Increased price transparency: Membership of the Euro should in practice make it easier for consumers and businesses to compare relative prices levels across member nations. This will encourage cross-border trade and increase the competitive pressures across many different markets. There are potential gains in consumer welfare if price transparency leads to improvements in allocative efficiency.
Business uncertainty and transactions costs: Joining the Euro would reduce exchange rate uncertainty for British businesses and lower transactions costs for companies and tourists. Nearly 60% of our trade in goods and services is conducted with other members of the European Union – a figure that will grow in future years
The Euro as a complement to the working of the Single Market: The Euro is vital as a complement to the success of the Single European Market. This should lead to an increase in intra-European trade flows and higher inward investment within the EU region.
Britain’s flexible labour market would enhance our performance within the Euro Zone: Britain's flexible labour market would be highly effective inside a single currency area and would help to attract even more inward investment from outside the EU.
Foreign investment flows and the development of UK multinational enterprises: Britain has been a major recipient of foreign direct investment in recent years. Some commentators believe this would be threatened if the UK remains outside the system in the long run. By removing a currency barrier to trade and potentially improving access to funding, EMU could also facilitate the development of UK-owned multinational enterprises.
Higher wages and employment for UK workers: EMU could have long-term benefits for households, including potentially lower prices and higher wages – although the potential benefits here do depend greatly on the degree of sustainable convergence between the UK and other Euro Zone countries
Political and economic influence: Britain stands to lose political and economic influence in shaping future economic integration if it remains outside the monetary system.

Transactions costs and price transparency explained

The Case against UK Participation

Critics of the Euro argue that the new currency does not meet the requirements of an optimal currency area and that structural differences between member nations threaten to undermine the success of the project. Other economists believe that the UK can continue to enjoy a sustained period of macroeconomic prosperity outside the Euro Zone whilst still deriving some of the benefits from participation in the single European market.

1. Past history and deflationary bias: Currency unions have collapsed in the past. There is no guarantee that EMU will be a success. It may indeed prove to be a recipe for economic stagnation including slower growth and high unemployment if the ECB pursues a deflationary monetary policy to keep inflation within the 2% limit. Many economists have been critical of the reluctance of the ECB to cut interest rates in a more aggressive manner during its first six and a half years in operation.
2. The Euro is not an optimal currency area: The Euro Zone does not meet the conditions required for an optimal currency area (OCA). By this we mean that within the Euro Zone countries there is immobility of labour and there is insufficient wage flexibility inside European labour markets to cope with the inevitable external economic shocks.
3. A lack of real economic convergence: Member economies have not converged fully in a real or structural sense. And, at some stage, there is a risk that excessively high interest rates will be set across the Euro Area because of an inflationary fear in one part of the zone that is unsuited to another area. This is the essence of the argument that in a currency union comprising many countries, it is virtually impossible for the official short-term interest rates to be at a level than is optimum for any one country.
4. Loss of domestic monetary policy freedom: Joining a single currency reduces Britain’s monetary policy autonomy. Britain might wish to retain the flexibility to set short term interest rates to meet her own internal macroeconomic objectives. Entry to the Euro Zone means a permanent transfer of domestic monetary sovereignty to the ECB.
5. Constraints of the fiscal stability pact: Countries joining the Euro signed up initially to the fiscal stability pact which limited the scale of government borrowing to 3% of national income. Several nations have already broken the conditions of the pact and it has now effectively been abandoned. But remaining outside the Euro Zone gives the UK a degree of fiscal policy freedom not available to member states.
6. Monetary policy asymmetry between the UK and the Euro Zone: There is plenty of evidence that the British economy is more sensitive to the effects of interest rate changes than other EU countries. In part this is because of the high scale of owner-occupation in the housing market on variable-rate mortgages. Joining a currency union with little monetary flexibility requires the UK to have more flexibility in labour markets, product markets and in the housing market. But the British rented housing sector is too small to be a good substitute for owner-occupation and major change will have to be made to the structure of housing finance. Another factor behind monetary policy asymmetry is that British companies rely more heavily on debt finance to pay for their investment projects rather than the issuing of new equity (shares) through the capital markets. They are more exposed to changes in interest rates than businesses in other EU countries.
7. Adjustment costs: The change over process to the introduction of the Euro will involve substantial menu costs for businesses and banks. These menu costs will bear heavily on small-medium sized enterprises.
8. Foreign investment issue: Opponents of Euro membership argue that Britain can continue to attract capital inflows outside of the Euro Zone. Favourable supply-side factors in both product and labour markets make the UK attractive for foreign investment.
9. The performance of the Bank of England since 1997: The Bank of England’s success in keeping inflation within target and at the same time changing interest rates to keep the economy on track for sustained growth, may have undermined the case for UK entry into the Euro Zone for the UK. Would macroeconomic performance using the Euro be noticeably better?

Why are UK interest rates higher than the Euro Zone?

The UK and the Euro Zone share a common inflation target – consumer price inflation of two per cent – yet we see a consistent difference between interest rates. Why is this happening?

The main reason for the divergence in interest rates is that each Central Bank take a different view of the risk of cost push and demand pull inflation. Historically inflation has been more of a problem for the UK than it has for continental economies of Western Europe especially Germany. Short term interest rates are often a clear guide to official expectations of inflation. The Bank of England has done a good job since 1997 of keeping inflation down and the economy growing, but there remains a residual fear of a return to higher wage inflation and some concern that rapid asset price inflation especially in the housing market could lead to too fast a growth of consumer spending.

Optimal Currency Areas

An OCA works best when the countries within it are already highly integrated with each other and where each has a sufficiently flexible labour market to cope with external economic shocks. The OCA is also likely to work well when the monetary policy transmission mechanism works in similar ways within each country – in other words, the effects of interest rate changes have a broadly similar impact on businesses and households, and the time lags involved in interest rate changes working their way through to affect output, employment and prices are pretty close to each other.

In most important respects, the Euro Zone is not an OCA – although a small group of countries within it are probably closely convergent in a structural sense. An OCA is better placed to succeed with a small cluster of countries rather than the looser coalition of twelve nations that count themselves as founder members of the single currency.

Another important issue for the UK is illustrated in the next figure.

The basic argument is this. A country might want all three of the features shown in the boxes below: Free capital mobility helps to attract inward investment and permits the free flow of investment capital overseas to take advantage of overseas investment opportunities. Secondly the freedom to pursue an independent domestic monetary policy (i.e. set your own interest rates to meet an inflation target or some other objective). Thirdly the benefits that might flow from having stable fixed exchange rate.

Only two of the three features can be chosen at any one time. If a country desires exchange rate stability and also capital mobility, it must use monetary policy to set interest rates to meet an exchange rate target. This was the case when the UK was a member of the exchange rate mechanism from October 1990 to September 1992. Interest rate policy was constrained by the need to keep sterling within the agreed bands of the ERM. Once the UK had left the ERM and moved to a free-floating exchange rate, this freed up domestic monetary policy. Interest rates could now be set to keep the growth of aggregate demand in line with aggregate supply so that the economy continued to grow but keeping inflation within target range.

At the moment the Government is keen to retain these two elements – a floating currency and an independent monetary policy. It believes that the Bank of England has done a good job in setting interest rates and the free flow of capital allows the balance of payments deficit on the current account to be financed whilst the sterling exchange rate is left to find its own level in the foreign exchange markets.

The 5 Economic Tests

The Labour government is committed to holding a binding referendum on the issue of the single currency before making a decision on entry. Gordon Brown has outlined five economic tests to be met before he will recommend membership of the single currency.

1. Economic Convergence: This test revolves around the following question. Are UK and Euro Zone business cycles and economic structures compatible so that we and others could live comfortably with euro interest rates on a permanent basis?
2. Economic Flexibility: This test considers whether there is sufficient flexibility in the system to cope with economic shocks. Brown wants there to be more flexibility in the European labour market and increased competitive pressures in markets for goods and services. Some of this may happen naturally (driven for example by the impact of the Internet) but the European labour markets may require root and branch reforms. The British government is certainly pushing strongly for wider economic reforms in Europe before it will countenance membership of the single currency
3. Investment: This test focuses on whether membership of the single currency has a beneficial effect on the level of capital investment across many sectors of the economy. This includes the potential impact of foreign direct investment from within and outside of the Euro Zone. Would joining EMU create better conditions for overseas firms making long-term decisions to invest in Britain?
4. The Financial Services Industry: This test is not the most important one. It considers the likely impact of Euro participation on the health of the UK's financial services industry
5. Employment: Whether the Euro is good in the long term for raising employment and reducing unemployment – according to the Treasury, this test can be summed up as follows: ‘Will joining EMU promote higher growth, stability and a lasting increase in jobs?’

The Importance of Economic Convergence

The idea of convergence is perceived to be the single most important test against which the UK government is assessing the costs and benefits of UK participation in the Euro. Countries are convergent for a monetary union are convergent if they have similar economic structures, so will respond to the same shocks in a similar way, and are unlikely to be hit by a large number of country-specific shocks.’ Three different types of convergence can be identified:

1. Cyclical convergence: This considers the extent to which the economic cycles of the UK and the Euro Zone have aligned sufficiently. Numerous indicators can be used to judge the degree of cyclical convergence – some of which are considered briefly below
2. Structural convergence: Economic structures in the UK and the Euro Area are compared and the implications in terms of aggregate demand and aggregate supply-side economic shocks and their impact on prices, output and jobs are assessed
3. Endogenous convergence:  Endogenous convergence describes the convergence that may occur as a result of joining EMU – for example the extent to which wage bargaining and price-setting might be affected by being inside a single currency area, or possible changes in the balance between fixed and variable rate borrowing for households and businesses.

Cyclical Convergence
The main indicators of cyclical convergence are

1. National output: The ‘base indicator’ of convergence is the rate of real GDP growth. The chart above tracks the growth rate for the UK and the Euro Zone.
2. Short-term interest rates: Interest rates are the main instrument for the monetary authorities in both the UK and the euro area. Differences in short-term interest rates indicate disparities in either inflation targets or perceived inflationary pressures
3. Real interest rates: Real interest rates are the nominal rate of interest adjusted for inflation – important as a factor influencing investment decisions by businesses
4. The output gap: The output gap is measured as the difference between actual and potential output. The output gap is used as an indicator of future inflationary pressure and is often at the forefront of decisions of central banks when setting interest rates to meet an inflation target
5. Labour market conditions: Labour market indicators would include the annual growth of wages and earnings, the rate of unemployment and surveys of skills shortages – reflecting the changing balance of labour demand and supply in an economy
6. Long-term interest rates and inflation expectations: These indicate the success and credibility of monetary policy and macroeconomic policy more generally. The long term rate of interest on ten year Government bonds is widely perceived as the bond markets best forecast of inflation expectations for a country going forward
7. The exchange rate: This is a further important indicator of the state of the economy because changes in the exchange rate can have a major effect on the pattern of demand and short term growth

Structural convergence

Structural convergence analyses whether the supply-side structures of the British economy might be different to countries within the Euro Area. And, if they are, the extent to which different structures could make the UK more vulnerable to economic shocks that do not affect the rest of the euro area (for example, volatility in house prices). There is also the risk that the UK could react differently to changes in circumstances that affect the whole of the monetary union (e.g. changes in Euro Zone interest rates).

The main structural features are:

1. The sector composition of national output (e.g. the contribution to GDP in each country made by manufacturing, services, agriculture and the energy industries)
2. Patterns of trade within and outside the Euro Area for each country
3. The structure of financial markets including the structure of finance used in housing markets
4. Differences in estimated equilibrium rates of unemployment – this affects the nature of the inflation – unemployment trade-off in each country and also impacts on how quickly an economy can grow without running into inflation problems. The evidence is that the Euro Zone has a poorer unemployment-inflation trade off indicated by differences in the estimated non-accelerating inflation rate of unemployment (NAIRU).

Consider the structure of output between the UK, Germany and France, details of which appear in the next table: Germany has a relatively larger manufacturing base. Indeed its short-run economic cycle is extremely closely tied to global trends in the strength of demand for manufactured goods. In contrast the UK has moved more decisively towards a post-industrial economy with nearly three-quarters of final output coming from the service sector.

Comparing the structure of GDP by sector across three countries
Per cent of total output, data is for 2001	UK	Germany	France
Agriculture, hunting, forestry, fishing	0.9	1.1	2.8
Manufacturing, mining, utilities	19.9	24.2	20.1
Construction	5.5	4.4	4.7
Distribution, hotels, transport, communications	22.9	18.6	19.3
Finance, real estate, other business activities	27.9	30.1	30.1
Public admin, social security, education, health, defence	22.8	21.6	23.1
Services total	73.6	70.2	72.4

 

Differences in the transmission mechanism of monetary policy
Taken together, the structural features discussed above will influence how monetary policy affects the real economy: the so-called monetary policy transmission mechanism. If a change in Euro Zone interest rates causes a different response in the UK compared to euro area countries, in terms of the speed of response or its overall effect on output and inflation, this might result in a divergent cyclical path or greater volatility of output and inflation in the UK. We have already referred to this as monetary policy asymmetry – and it is a hugely important aspect of the Euro debate.