Unit 4 Macro: The UK Economy and the Euro

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. Were they 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.

The potential benefits of currency benefit for these countries in the euro have been expounded repeatedly, but they are not without limitations. Firstly, currency devaluation is functionally similar to default: those who bought bonds in that currency see their assets cut in much the same way they would if default occurred. The greater control the European Central Bank would have over a default would, however, arguably mean that default is a preferable option. Furthermore, the benefits of a devalued currency to trade are often either temporary or must be paid elsewhere, by the hit taken to consumers thanks to the increased cost of imports. Although in the long run the restructuring to the economy caused by this action may well be beneficial, the negative short term impacts on consumers could mean that currency devaluation would be unwise. Countries such as Spain and Greece are not necessarily benefitting from being unable to devalue their currency, but the extent to which they are losing out is limited. As such, the benefit to the UK of having a floating currency is perhaps not as large as some advocates might suggest.

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 (Mundell) 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.

However, even if the base rate is universal between all the countries in the Euro zone, functionally, domestic interest rates can vary significantly. Lending rates are often much higher than base rates, as if banks are more cautious about the risks of lending in an unfavourable climate, they will increase the rates they charge on borrowed money in order to reduce the risk of losing money. Such defensive practices are much more likely to be seen in countries such as Spain than in more stable nations like Germany. As such, the negative effects of the universal interest rate may be limited. Furthermore, the ECB’s base rate is similar to the Bank of England’s; both cut policy rates aggressively in the wake of the crisis, with a difference of only 0.3 percentage points between short term interest rates in 2012. Furthermore, similar levels of inflation (2.6% vs. 2.4% in 2012) mean that the effects of these low base rates will be similar on average in both Britain and the Euro zone, because real interest rates are similar. Consequently, it is unlikely that Britain has experienced a significant advantage from having independent monetary policy.

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.