The Cases For Joining The Euro Economics Essay

Published: Last Edited:

This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.

The theory of OCA was pioneered by Robert Mundell in 1961. This economic theory offers to analyse the conditions for reducing the costs and maximizing the benefits of forming or joining a monetary union. The country is said to be optimal currency area when similarities between the economic structures of countries make it feasible to adopt a single currency. There are numbers of single currency areas all around the world in the form of integrate and pegging system. European Union and Caribbean dollar are the successful example. Adopting single currency decision is always complex and often based on countries political, economical and historical roots. Adoption of Deutche Mark in 1990 by Eastern Germany (1), poor economic condition of El Salvador (2) and historical roots of Hong-Kong (pegged with US dollar) (3) respectively are the good reference for this complexity.

According to the literature, OCA theory can be laid down in two dimensions. The first dimension tries to find the economic variable to determine where the boarders of the single currency should be drawn. The second dimension believes that any single country can be an optimal member of a monetary union if they fulfil the requirements. After World War 2, when the exchange rate regime established, countries reluctant to think about both of the facet of OCA. USA than allowed its dollar to easily convertible to a fixed amount of gold to make its currency more stable. As a result, many countries noticed US dollar as a stable currency and therefore either adopted it or pegged the value of national currencies to the US dollar.

However, the concept of fixed exchange rate received a lot of attention but there were also few researchers like Friedman (1953) who stated that the only country can cope with the exogenous shock that have flexible exchange rate. Later this hypothesis used by Mundell (1961) to develop the OCA in which he stated that the creation of single currency based on the two factors mobility that is external and internal. Mundell's OCA theory received a lot of criticism because of unrealistic and simplistic assumption for instant Philips curve which were used to develop that have been criticised in 1960-1970's. Mc Kinnon also argued that the OCA model is full on neo- Keynesian theory.

The cases for joining the EURO-

In the essence, the argument is that why the UK should join the euro. Numerous cases have been already discussed by various economists. Djflsf is one who published the cases for and against of adopting the EURO.

To figure it out one side the five tests were designed by former British labour party chancellor, Gordon brown in 1997 for assessing the entry of Britain's into the EMU. The membership of EMU means that the UK would adopt the EURO as its currency and UK interest rates would be set by the European central bank (ECB). This could be done by evaluating economic conditions and the interest of the British people. The five tests were-:

1. Whether there can be sustainable convergence between Britain and the economies of a single currency.

2. Whether there is sufficient flexibility to cope with economic change.

3. The effect on investment.

4. The impact on our financial services industry.

5. Whether it is good for employment.

The main argument issuing around the single currency criteria is an increase in the volume of trade. Trade is an interest primarily factor for an economic growth. The international trade theory strongly believes that "increased openness can increase productivity and hence real output and incomes". Latest technology in the modern world allows countries to reduce the transportation cost and with further elimination of exchange rate boost the trade. Meanwhile, foreign investment in UK will increase and the cost of capital will reduce. These all means that, the trade among the integrated countries likely to boost. The HMT treasury stated that, "Our assessment makes clear that, with the advent of the single currency, trade within the euro area has already expanded and that, with Britain in the euro, British trade with the euro area could increase substantially - perhaps to the extent of 50 per cent over 30 years."

Although, the rose finding cleared that, the currency union seemed to have a large effect on trade. "One of these studies concluded that the member of currency union traded over three time as much as otherwise similar pairs of countries" (4). With effect of increase trade in intraregional, the case for economic divergence decrease. Which means every countries economy would become more likely each others. Meanwhile, the asymmetric shocks reduced. Simultaneously, the sign of business synchronisation emerge which leads greater integration between countries (5). Furthermore, to access in greater integration especially when integration take place due to the transportation cost, the accessing countries should be specialised in goods and services to get benefit for the long term period (6). Significant indication has been noticed by Elliot (2008) that, the European countries with having comparative advantage in specialising sector changing the shape of European economy. Since financial sector is the comparative advantage of the UK economy. If the UK joins the EURO ZONE, it would access more integrated European capital market than now.

Conversely, the reasons that why UK decided not to join the Euro Zone were mainly interest rate and lack of convergence in economic. The UK interest rate was substantially higher than EU during HM first assessment. After that, significant efforts were shown to meet the EU criteria to allow the UK to join. According to the Gordon brown statement "we have pursued since 1997 - an independent central bank, new fiscal rules, lower debt, housing market reform, greater flexibility in labour, capital and product markets including an independent Competition Commission - have contributed to meeting, quite comfortably, the Maastricht criteria for nominal convergence - in a better position than some current members were in 1997 and even are now - but are also leading towards the sustainable convergence and greater flexibility required by the five tests." (7). Currently if we look at the economic convergence and interest rate figures then we can find out that both legal formalities are already met since 2003. The only reason for not joined is that "we were not sure whether this rate of convergence relevant for long term or not". The core element included housing market and inflation rate which were also the solid key factors against the EURO. However, the sub-prime recession fully vaporised both obstacle. Resulted, fear for loss of competitiveness due to high inflation rates for the UK reduced. Correspondingly, the value of UK and Euro is very similar because of weakness in UK pound. The chart below shows the cyclical convergence between UK and the EURO and the long term real interest rates in EURO area and the UK.

Cyclical convergence between the UK and the Euro

The above chart (cited by buiter) clearly shows that the cyclical convergence and long term interest rate between both countries already met since 2003.

Apart from this, the thing left solved during HM treasury assessment was housing market. Housing market in the UK was much stronger than the rest of the EU. But recently global financial crises collapse the UK mortgage market. The housing market stood at the bottom level as compared to the past experience (8). Respectively, the argument for housing market coincides between UK and EU also does not hold much value than before. "The UK model of housing finance is broken. Measures to encourage truly long-term fixed-rate financing (20-year or 30-year fixed rate mortgages) are long overdue. New mortgage financing has collapsed, the securitisation of new mortgages has grounded to a halt, and the construction sector (residential and commercial) is teetering on the brink of disaster" (9).

It has been already discussed extendedly by many economics whether adopting Euro will be beneficial to the UK or not (Minford, Artis, Buiter). The core argument for all these studies was "floating exchange rate". Is floating exchange rate should be better equipped to adapt to economic shocks? This is complex in nature and sometime in certain cases it is true though. For example, floating exchange rate enable the countries to dampen the impact of shocks and hence allow economy to` recover more rapidly than others. Although, the benefits of monetary autonomy still be present if the exchange rate is driven by non- fundamental factors. The factors that drive the exchange rate enable to confer on the central bank autonomy to determine the existing amount of base money and use that as a policy instrument by setting domestic short term interest rates (10). In the case of preventing shocks corsetti (2007) presented the model in which he concluded that both fixed and floating exchange rate fails equally adhere to fundamentals (11)

Is UK unwilling to join EMU just because they consider the floating exchange as a benefit tool for economic prosperity or because they afraid from the past experience to repeat again which they had in 1992? DiCecio et al, (2009) concluded that if UK joined the Euro area they still felt the economic shocks as they fell now via different channels. They also concluded that the economic stability also diminishes under monetary union if goods are imports from euro area as primarily intermediates instead of finished goods.

Why shouldn't the UK join the EURO?

With delivering extensive benefits to the participating economies, single currency also imposes costs. According to the McKinnon (2002), the major reasons why a country should not join single currency are: loss of monetary autonomy in response to asymmetric shocks and unstable monetary standard. McKinnon stated that "in the world there is no sufficiently stable monetary standard". The national government of the countries reluctantly give up its sovereignty if they tie up with single currency. Immediately entry would impose numerous economic shocks and that would affect on economy as a whole.

Loss of the control over the monetary policy is the one of the main arguments issuing around "why the UK should not join the EU"? Monetary policy are jointly controlled by the countries with having only one single currency which means if exogenous shocks occur in any country they will not be able to protect itself via shifting its interest rates or exchange rates. Indeed, Due to the linkage to the dominant trading partners, the Single currency can provide the necessary stability normally for the smaller open economies. However, for the UK to be linking with other dominant countries would be pointless because it will also taking the exogenous shocks of smaller economies.

Although, it does not necessary that joining monetary union means the end of the independent fiscal policy for its member states. The fully monetary union countries can keep their fiscal policies independent. However, in order to adjust the asymmetric shock in common currency area, some centralised decision could need to be achieved. Typically, centralisation budgets often imposed to an increase in spending. (hv). Clearly, The UK has no reason to fear for any type of reduction in fiscal policy by joining the Euro zone to manage its national economy (buit).

The Loss of control over sovereignty is also important to mention because it assumed to be an important source of fiscal revenues and it is often argued to be a major disadvantage of adopting single currency. Literally, no hard concept is applicable for measuring sovereignty. Eventually, the choice of concept is depends on the specific environment in which base money is created. Due to this, the fiscal concept is considered as a most general concept for measuring sovereignty (seig). Theoretically, to fight against the increasing debts, the government should not opt out for printing money because this leads to increase in inflation. However, in practice, the volatility of economic cycles pushes country economy into critical recessions. At that stage, government reluctant to look over sovereignty to fix problem as early as possible before the economic totally collapse. For example the "sub-prime mortgage recession" in US combined with budget deficit forced the US government to print money to avoid their economy collapse. Aftermath, the sub-prime mortgage recession triggered the financial crises all over the world. With effect, UK also pumped half of billion in the economy for recovery hope (12). "Should the UK join the EU", this option was also available for UK but due to the risk of uncertainty in economic recovery and imbalance between economically and politically reasons, this option halt to the ground.

Apart from the sovereign, the volatility of exchange rates also has negative effects on economic calculation. However, this volatility helps to the stock market to make huge money. Furthermore, during the sub-prime recession period until it hits to UK financial sector, UK consumers enjoyed a higher welfare gains than any other USA or European countries because of strong position of pound. But, if there is uncertainty in exchange rate, the expected profit of investment will be low which could lead positive effect on output. Hence, theoretical outcome related to volatility of exchange rate is ambiguous (Horvath et al , 2002 p 14).

Among the countries if the economic cycles are synchronized, the chances of asymmetric shocks increase. Mostly, European countries (especially industrial countries) are doing intra industrial trade based on economies of scale and imperfect competition. That allows countries to increase trade without increase in specialisation growth. Hence, the asymmetric shocks likely to decreases (Harvath et al 2002 p 15). Also, if Krugman's argument becomes true then, those shocks may become more severe. Countries then need to be specialised in goods to cope with shocks. Furthermore, those shocks expected to strike on concentrated areas which already have a strong bonding to cope. Correspondingly, the problem with Krugman's view is that it implicitly assumes that regional concentration of industry will not cross the borders of the countries that formed the union, while borders will be less relevant in influencing the shape of these concentration effects. If so, then asymmetric shock is not country specific and floating exchange rate variation could not be used to deal with asymmetric shocks anyway" (Horvath et al, 2002, p. 16).

Another argument at the glance in monetary union is "trade increases". Theoretically, with increases the trade inside the euro tends likely to decrease the trade outside the euro. As a result, the area become less prone to external shocks and makes it easier to deal with the systematic shocks. But is that work in real? For instance, with the US sub-prime mortgage crisis, countries within the euro area suffered as much as outside the euro. It is so, because subprime crises triggered the whole financial market and further extended to the global trade. In contrast, the fact is that the existence of trade within the euro area failed the countries to protect from external shocks and hence also become the victim. It can also be argued that the integrated trade with the presence of multinational companies in large geographical area will also not protect the countries against the financial shocks. Similarly, the example can be lay down from oil prices. The oil price shocks quickly translated to the current economic whether it is inside or outside the OCA because of limited supply of oil and with great demand.

According to the Rose and Frankel (1998), countries should follow the similar economic cycle in order to join single currency. Furthermore, the more the integrated trade between countries having same currency the more their economic cycle converge. So the argument for pre- joining criteria for single currency is not necessary. Harvath also mentioned that the EMU entry raises the trade within the single currency that causes the business cycle more convergent to participate.

UK highly depends on the profits of the city and the housing market which keeps the UK economy different than any euro country. And it is also noticeable that if they had joined the euro than the situation become worst for the UK economy especially during the recession which is still ongoing. "Interest rates would have been lower when the housing bubble was being inflated and they would have been higher when the bubble was deflating. That is precisely the problem Spain has had" (Elliott, 2008).