By Lydia Luff
The Eurozone is a currency union. The 19 countries that use the Euro as their currency are part of the Eurozone. The United Kingdom is one of the remaining 9 countries who are within the European Union (EU) trading bloc however have kept their currencies. In 1969, the UK was officially allowed to join the EU and after negotiations, joined at the beginning of 1973. This relationship, among many other things, allowed the UK to trade freely with other members of the EU. People, like goods, could also move between countries without complication. But wouldn’t it have just been easier for everyone involved if the UK had also adopted the Euro? Imagine that, no exchange rates to grapple with when going on holiday! No more trying to work out prices when buying things from mainland Europe! Sounds like a dream! So why didn’t the UK take on the Euro?
An exchange rate is the price of one currency in terms of another currency, for example, how many pounds can you buy with one euro. The UK currently has a floating exchange rate, which means that the Bank of England does not intervene to maintain the exchange rate; it ‘floats’ and corrects itself. The Eurozone also has a floating exchange rate. Although lots of countries use the Euro, they act as one and the value of the euro is the same in every country. All the economies of the countries in the Eurozone are somewhat aligned, to maintain the value of the currency among the different countries. The European Central Bank is responsible for implementing monetary policy across the whole of the Eurozone, which means it sets the base rate that other banks can borrow at. This has to be the case to maintain the common currency because if interest rates differed from country to country, investors would all want to deposit their money in the countries with higher interest rates. Therefore, the monetary policy enforced by eurozone countries is identical and this helps to maintain the value of the currency across countries.
To join the Eurozone, the UK would have had to meet certain conditions. As of 1991, these criteria included: proof of controlled inflation; avoidance of excessive government budget deficit; exchange rate consistency and constant interest rates.
Despite the challenging steps the UK would have had to make to use the common currency, many academics supported the idea of the UK joining the Eurozone. There seems to be three key arguments put forward for this. Firstly, transaction costs would be lower. This would be due to people no longer having to exchange currency. This benefit, although questioned since transaction costs are often cancelled out by the exchange rate anyway, would be continuous. Some estimate the saving to equal approximately 0.1% of GDP (roughly £1 billion). Secondly, as demonstrated in figure 1 using data from the Bank of England, the euro to pound exchange rate is volatile. This is particularly noticeable around the time of the financial crisis of 2007/2008. On 30thSeptember 2007, you could buy €1.47 with £1, however just 18 months later you could only buy €1.10 with £1. This generates huge risks with regards to multimillion-pound investments, where profits may depend partially on the exchange rate. Not to mention, it could make your holiday a lot more expensive! Joining the Eurozone would mean this exchange rate risk between the UK and Eurozone would be eliminated.
And finally, if the UK did join the Eurozone, there would have been more transparency with prices. We would no longer have to use the exchange rate to compare prices in pounds and euros. Anyone could easily see how the price of a good produced in France compared with the price of the good in the UK.
These three arguments are the main reasons some Economists, including Willem Buiter, believe that joining the Eurozone would have been beneficial to the UK.
This ongoing debate has also led to other Economists speaking out about why they don’t think the UK should have joined the Eurozone. But other than the sheer cost of physically changing every single pound coin and bank note from one currency to another, what concerns have there been? If the UK were to join the Eurozone, the government would have to maintain the value of euros so that it remained in line with other countries. This would result in (as mentioned above) the UK government, just like all the other Eurozone governments, losing control of their monetary policy. Currently, the UK government sets its own inflation target (2% at the moment). The Bank of England’s main aims are to maintain monetary and financial stability. One of the ways it achieves this is by altering the interest rate. With the European Central Bank setting inflation targets and interest rates for the whole of the Eurozone, what would happen if either of these rates did not suit the UK? Figure 2 and 3 show the history of the UK’s base rate and the Eurozone’s base rate. As you can see, although the general movements of the rates are somewhat aligned (for example, both rates were reduced significantly after the Financial Crisis), the Eurozone interest rates have differed from the UK rates. The Bank of England set those interest rates to meet its aims that are specifically targeted to improve the UK’s economy. Loss of control over its own base rate could therefore be very detrimental to the UK economy.
Another interesting issue would be that the UK would lose the ability to issue debt in its own currency. Imagine this hypothetical situation. The UK has joined the Eurozone. You are an investor and you believe that the UK government may default. You would sell your UK government bonds and take your Euros to another country, lowering the liquidity of the UK government. This would result in the government defaulting as they cannot simply demand the European Central Bank prints more money for them. Whereas, because the UK still has Sterling as its currency, the number of pounds within the UK will not change. Even if there was fear of default, the currency would not leave the UK market. The money would be reinvested at some point in the future and the liquidity of the government would remain virtually unchanged. This is one of the main arguments presented by Professor Paul De Grauwe in his paper ‘Managing a Fragile Eurozone’.
The fact that this debate has been going on since the UK joined the EU demonstrates there is no simple answer as to whether we should adopt the Euro. There are many reasons, some economic, that the UK didn’t join the Eurozone including loss of monetary policy control and loss of ability to issue debt. However, these may have been outweighed by the benefits if we had joined the currency bloc. It must be remembered that Economics cannot predict what would have happened to the UK’s economy had we joined. All that can be said for sure is that it is lucky the UK never did join considering the Brexit vote and deal that is now being negotiated. Brexit would have been significantly more complicated if one of the steps had been leaving a monetary union. People are in uproar considering how much money and time it will take to swap back to the old passports, imagine if all the money in the UK was also being swapped back again!
This blog post was originally written by Lydia Luff as an assessment for the Third Year module International Macroeconomics. It has been reposted on the School’s Blog with the author’s consent, only minor editorial changes have been made. The original blog can be viewed here.
Nice article..