Europe Revision: The Euro

Revision notes on aspects of the EU single currency - is the UK economy better off outside of the Euro?

Economics of the Single Currency

• ECB sets policy interest rates for the sixteen participating nations
• ECB objective is price stability – CPI inflation of 2% or below
• No explicit exchange rate target but some currency intervention
• Member nations of Euro must sign up to fiscal stability pact but this pact has been loosened because of the effects of the credit crunch / recession
• Countries joining the Euro must meet the convergence criteria (see below)

Convergence Criteria for joining the Euro
1. Stable prices: Inflation must not be more than 1.5% 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:
a. Total government debt must not exceed 60 per cent of GDP.
b. The annual budget deficit must not be greater than 3 per cent of GDP.
4. Interest rate convergence: 5-year Treasury bond interest rate must not be more than 2 percentage points higher than average of Euro Zone members

Real convergence
Some economists believe that economies entering the single currency are likely to perform better in the long run if members are closer in a real sense i.e.

• Trend growth of GDP (linked to productivity growth & investment)
• Labour market flexibility e.g. flexible skills, mobility, flexible wages
• Patterns of international trade are similar
• Housing market structure e.g. home ownership, mortgage finance
• Countries whose economies respond in a symmetrical way to a change in monetary policy e.g. when the ECB makes a change to policy rates

Because the sixteen member nations of the Euro are very different – this makes it virtually impossible for the ECB to find a ‘one-size fits all’ interest rate.

Optimal currency area (OCA)

1. An optimal currency area (OCA) is a geographical region where it is thought a single currency would help to maximise economic welfare.
2. An OCA tends to work 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 shocks such as rising oil prices or a major demand-side shock in the world economy.
3. OCA is also likely to work well when the impact of interest rate changes have a broadly similar effect on businesses and households from country to country.

10 Years of the Euro - Has the Single Currency Worked?

1. Has it contributed to sustained economic growth and low inflation?
2. Is there evidence of price convergence within the single market?
3. Has the Euro Zone’s global competitiveness improved?
4. How well have new member states performed within the system?

Successes:

• Euro has quickly established itself as a major world currency
• ECB has managed to maintain price stability despite external shocks
• Expansion of the currency zone (16 nations) that has been smooth
• Until 2008 the Euro Zone economy enjoyed good growth

But – a major economic crisis for the Euro Zone in 2009

• This is a very unusual economic cycle – the global economy fell off a cliff in second half of 2008
• Germany’s rate of decline has been exceptional - Europe’s biggest economy - it and most other EU countries now have a huge output gap
• Deep recession and risk of deflation – big 4 inside Euro all suffering steep slump in production with manufacturing & construction badly hit
• Rising unemployment (already high) – EA Unemp heading to 9% and Spanish unemployment expected to rise above 20%.
• Worsening fiscal deficits and rising government debt
• Fiscal stability pact effectively dropped as individual nations scramble to organize fiscal stimulus packages for their economy inc bail outs & subsidies
• Banking crisis – partly due to huge rise in Euro lending to new EU nations
• Strong Euro making life very tough for exporters
• Many peripheral Euro Area countries struggling badly e.g. Greece, Ireland, Italy, Portugal and Spain and slump in exports from new EU countries
• Huge divergence in competitiveness shown in widening trade imbalances
• No chance of nominal exchange rate adjustment (this is an option for the UK!)
• So downward pressure on wages and jobs and living standards
• Fall in public support for the Euro / social unrest / political pressures
• Several Baltic States hit hard by having currency peg to strong Euro – Latvia has seen real GDP slump by more than 15% in less than 12 months.

UK and the Euro
1. UK opted out of the Euro when it signed the 1993 Maastricht Treaty
2. Bank of England independence in 1997, creation of the MPC
3. Revised inflation target – switched to CPI target of 2.0% in December 2003
4. For most of the last decade UK growth has been above that of the Euro Zone
5. Unemployment has been lower (although the gap has closed)
6. Inflation slightly higher – partly because of stronger growth and credit/housing boom
7. Reflected in higher policy interest rates to keep inflationary pressures in check
8. Economic cycles of the Euro Zone and the UK have been quite closely aligned
9. Supporters of staying out of the Euro argue that the UK has more freedom to use macro policies to stabilize the economy at times of external shocks
10. E.g. pound sterling has depreciated by more than 25% against the Euro – giving the UK a significant competitive boost during the current recession.
11. But credibility of BoE has been damaged by the fall out from the credit crunch