Great Britain and the Euro

Great Britain and the Euro

Why Should the British Pound Join the Euro?

Macroeconomics in the Global EconomyProfessor Loïc Sadoulet

Maxime Cornu-Thenard, Mauro Correa, Jennifer Flood, Marton Hunek, Hong Jing Liang

Group 2 Section E1

Great Britain and the Euro The British Pound Should Join the Euro

INSEAD, February 2004

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The UK has long been pondering whether or not to join the Euro Zone and adopt the single currency. We strongly believe that benefits to becoming a member of the Euro Zone significantly outweigh the costs. By adopting the euro, the UK will see substantial improvements in foreign trade, foreign direct investment (FDI), and output in the long-term, which will all increase the standard of living. Therefore, we recommend that the UK commits now to adopt the single European currency.

1. The isolation of the pound increases costs, hampers the competitiveness of UK-based firms and consequently increases unemployment

The recent overvaluation of the pound against the euro has generated a large trade deficit with the Euro Zone. On the microeconomic level, firms in the UK have faced relatively more expensive production inputs (cost of capital and unit labor cost – see Graph 1). Because the pound is overvalued vs. the euro and production costs are relatively higher in the UK, productive foreign direct investment has decreased (see Graph 3 on page 3); and consequently interest rates and so the cost of capital is higher for UK firms. Also, one may argue that as wages go up, disposable income and consumption go up, generating inflationary pressures and making the Bank of England keep high interest rates not to allow an “overheating economy”. This vicious cycle might be avoided and companies would experience greater competitiveness should the UK joined the euro.

Graph no. 1

Real Unit Labor Cost in the UK, Germany and France(Performance relative to the 14 other EU countries, 1995 = 100)

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Source: Eurostat

If the introduction of the euro is further delayed, FDI-inflow will further decline, and currently UK-based firms will relocate their facilities to other countries (increased FDI-outflow.) Both of these factors will mean a reduction in the investment levels in the economy, higher unemployment, further upward pressure on interest rates. In fact, French and German firms are already an integrated part of the Euro-Zone, and they currently enjoy significant competitive advantages over their UK competitors.

One good example that supports our claim is the auto industry. Since 2001, the big car-manufacturing companies have clearly expressed their dissatisfaction with the consequences of the ruling out of British membership in the euro. Unless the pound has joined the euro by 2006, union leaders and car manufacturers agree that further serious damage will be done to UK manufacturing. For instance, the head of Ford in Europe, Nick Scheele, has warned that “Ford’s strategic planning – on which 50,000 UK jobs rest – was based on euro-entry by the middle of the decade” 1. Not only Ford, but also GM and Nissan, whose highly productive Sunderland plant employs 5,000 people, are all cutting back

1 www.guardian.co.uk; “Britain must join euro, says car industry”.Macroeconomics Group 2, Section E1in the Global Economy 1 of 7 MBA Promotion Sept 2003

http://www.guardian.co.uk/


investment. In fact, Nissan already threatened to move the production facilities of their new Micra model to France.

Moreover, the fluctuation of the GBP-EUR exchange rate (see Graph 2) increases the business risk of trade partners in the UK and the Euro-Zone. This exchange rate risk has a negative effect on UK investment levels, as well. As Mr. Scheele protested: “More than 60% of Ford’s UK output goes to the Euro-Zone – at a 40% disadvantage since the euro’s collapse against the pound (…) our strategic planning has always been on the basis that the UK would ultimately enter the euro”. Tadaaki Jagawa, executive vice president at Toyota, added concerns when analyzing investors’ vulnerability to swings in the value of the pound: “First you will see the suppliers leave, and then the automakers will begin to cut production, with their factories going to one shift”. Also in 2001, Honda decided to turn to the Continent to get more parts for its English plant in Swindon, and currency-related losses played a major role in BMW’s decision to sell Rover Group.

Graph no. 2The GBP/ECU-EUR Exchange Rate Movements between 1990-2004

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As we can see from the example in the auto maker industry, the possibility of currency fluctuations (see Graph 2) creates business risk that impedes investment, deters medium-sized firms (of which the UK has many) from expanding abroad and diverts management attention towards exchange rate risk management and away from concentrating on increasing the business’ operational productivity, cost cutting and quality improvements. Furthermore, although the imperfect monetary union of the ERM is said to have been a failure we can see the lower volatility of the exchange rate between January 1990 and September 1992. In the long-term, unless the UK joins the euro, it is naturally expected that firms will relocate to outside the UK to boost productivity; in turn, higher unemployment and lower output levels are expected in the UK.

The negative effects of this can already be noticed. Between 1996/98 and 1999-2000, annual cross-border FDI has increased four-fold within the Euro Zone. At the same time, the UK’s share of FDI coming into the EU has fallen by 50% between 1997/98 and 1999-2001.

Graph no. 3 – Evolution of EU-15 FDI levels in the UK

Macroeconomics Group 2, Section E1in the Global Economy 2 of 7 MBA Promotion Sept 2003


In fact, we can see that the UK has faced an increasing decline in its FDI-flows with EU-15 countries as well. Out of the total FDI outflows from EU-15, the share invested in the UK decreased from 14,1% in 1998 to 4,4% in 2002 (see Graph 3). This trend is likely to have worsened in 2003, when total FDI-inflow to the UK decreased by approx. 50%.

Source: Eurostat and Bank of England2. The adoption of the single currency could enhance productivity through increased trade and investment and by stimulating competition

First of all, price transparency resulting from having a single currency will increase trade and productivity. Until now, major Pan-European companies have used price discrimination to charge the highest price that they could obtain in each nation. However, with the single currency stimulating further economic integration, prices will converge towards a single price within the Euro-Zone. In particular, business-to-business deals will increasingly arbitrage cross-border price discrepancies. While businesses and consumers in the UK will enjoy easy access to more goods and services at similar prices as on the continent, the UK companies will be subject to more intense competitive pressures, which will in turn stimulate faster productivity growth. The lack of exchange rate risks will increase FDI-inflow, which will create jobs and increase productivity through technology transfer.

Joining the Euro-Zone will further integrate the UK capital market with those of Europe. This integration will give UK companies a better access to capital across the Euro-Zone. Since capital will finally be (“de facto”) free to pursue the investment opportunities with the highest-return, pressure on UK managers will increase, pushing for higher productivity.

3. Joining the Euro will yield substantial benefits in trade and consequently economic growth

Several studies have statistically proven that currency unions have a positive effect on trade, and that they are associated with the doubling of external trade2. The beneficial effects of external trade on an economy have already been identified by Adam Smith, who argued that “… if a foreign country can supply us with a commodity cheaper than we ourselves can make it, [we had] better buy it of them with some part of our own industry, employed in a way in which we have some advantage3.” Trade between nations will lead to an expansion in total output and mutual gain for each trading partner when each country specializes in the production of goods it can produce at a relatively low cost and uses the proceeds to buy goods that it could produce only at a high cost.

The UK is a medium-sized economy, more and more dependent on external trade, which amounts to 40% of its GDP (see Graph 4) with an increasing proportion of it done with the Euro-Zone.

2 Andrew K. Rose: The Effect of Common Currencies on International Trade: A Meta-Analysis, April 8, 2002. This paper extensively analyses data collected by 15 different studies on the effects of monetary unions on external trade.3 Adam Smith, An inquiry into the Nature and Causes of the Wealth of Nations (1776; Cannan’s ed., Chicago: University of Chicago Press, 1976)



Graph no. 4

External Trade as a Percentage of GDP in the UK

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The UK should join the Euro-Zone because it has more than 50% of its foreign trade with it. (see Graph 5). This means that the UK’s main trading partner is the European Union (and mainly the countries in the Euro-Zone). If the UK adopted the euro, then the “one market, one money” principle would be more applicable and producers could reach more consumers and could buy from a wider range of suppliers (trade with the EU-15 would increase).

However, formal free trade is not enough to create a truly single market. Open economies are indeed vulnerable to damaging exchange rate fluctuations (see Graph 2). These unpredictable fluctuations result in lower than potential trade with other Euro-Zone economies as UK and Euro-Zone firms are both more reluctant to take on the exchange rate risk. This represents a loss of opportunity for UK (and Continental) businesses.

For instance, we saw that since 1998 companies willing to sell into the massive continental market have increasingly invested inside the Euro-Zone because they can accrue their costs and revenues in the same currency. Since 1998, trade between Euro-Zone countries has increased 20% faster than GDP, while trade between the UK and the Euro-Zone has been stagnant relative to GDP (see Table 1):

Trade with other EU Countries (as % of GDP)Table 1

France Germany UK1998 28% 27% 23%2001 32% 32% 22%Change +4% +5% -1%Source: Eurostat (Comext); UN (Comtrade); Trade in goods (sum of exports and imports)

Fluctuating currencies thus discourage trade. The data in Graph 5 demonstrates how the favourable trend of increasing UK trade with the EU-15 has turned around after the British Pound left the ERM in 1992. Up until 1992 the EU-15 accounted for an increasing proportion of the UK’s External Trade, (compounded annual growth rate (CAGR) of 3,0%) growing from 22% in 1960 to almost 60% in 1992. Since 1992, however, there has been a negative (-1,1%) annual decline to around 50% in 2003. If one accepts that the ERM was some kind of an (imperfect) monetary union4, than we can notice the effect of the UK’s “departure” on the relative decline of external trade with the EU-15.

Graph no. 5

4 It was a different system from the euro, as the ERM tried to link different currencies while retaining national monetary autonomy. In the Euro-zone there is one single currency and one single monetary policy.



Proportion of UK's External Trade with the EU-15

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Finally, it is also argued that an independent exchange rate can itself be a source of shocks to an economy rather than a means of offsetting them. Such shocks can have a quite large effect on the UK’s mid-sized and open economy. It is true that in small, open economies, monetary policy is more efficient with flexible exchange rates, while on the other hand fiscal policy is less effective in this case. Many monetarists thus argue that the UK’s recent relatively good economic performance (and compliance with the Stability Pact) is due to the fact that the pound if freely floating against the Euro, and that the UK has its independent monetary policy. It is partially true, as the theory suggests that to stimulate the economy fiscal policy should not be used in the UK as it would be ineffective anyway. Hence the UK budget deficit and indebtedness is low. On the other hand, however, should the UK join the Euro-Zone it would no longer be a small open economy, but part of the world’s second largest, almost closed trading block, comparable to the US. Due to the fact that the Euro-Zone is more similar to a closed-economy, the independent UK monetary policy and the exchange rate would play a much smaller role in the stimulation of the economy.

4. The Loss of UK’s Political and Economic Influence

If the UK does not join the Euro-Zone, does it risk becoming more of an “outsider”, and if so, will it maintain its economic and political influence?

The UK’s economy is heavily dependent on Europe, both on a microeconomic and macroeconomic level. Membership in the European Union means that the UK has already accepted a series of microeconomic measures such as financial services regulations, consumer protection, environmental standards, competition law, and more. Given that, the argument against joining the Euro-Zone in order to insure the UK’s independence falls short. In fact, by joining the Euro-Zone, the UK may find that they have greater influence on the policies that ultimately affect them. Additionally, there is the threat that policy ideas develop during the euro-12 discussions in which the UK does not participate. If this is the case, they have even less control as economic reform issues are more difficult to impact in the later stages of development. On a macroeconomic level, the UK has no platform from which to influence the EU policy since the monetary policy is conducted by the European Central Bank in Frankfurt. Given that, the UK’s economy is more vulnerable to the booms and busts in the Euro-Zone caused by changes in ECB policies especially since they have no voice in the matter.

In addition to economic reasons, there is the question of how the UK’s commitment and partnership is seen in the EU as a whole, especially as more countries move into the EU and adopt the euro overtime. Will the UK be the only EU member “outside” the Euro-Zone? If so, how much influence can an “outsider” really have over the core policies set within the European Union?


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Graph no. 7 – Convergence of UK andEuro-Zone business cycles


Finally, is there another role that the UK can play that euro membership will limit? One such relationship is undeniably their partnership with the United States. However, it is important to remember that part of this unity is due to the US’s reliance on the UK’s ability to influence Europe. Again, an “outsider” status does not leave the UK with much political leverage and consequently, less appeal to the US.

5. Myths that support the detachment of the British Pound from the Euro

a) Why loss of monetary sovereignty is not a big deal

Joining the EMU would mean that the UK would adopt the euro as its currency and UK interest rates would be set by the European Central Bank, on the basis of economic conditions in the euro area as a whole. The UK would also have to comply with the EU Stability and Growth Pact (inflation, fiscal deficit, government debt). The common fear of euro-skeptics is that if the UK falls in a recession but not the rest of the Euro-Zone (what is less and less likely due to the increasing close integration), the UK will struggle to get out of recession because of limited macroeconomic policy tools (largely limited to independent fiscal policy) to do so. This argument is largely unfounded.

- The UK already complies with the EU Stability and Growth Pact requirements5 (see Graph 6). Therefore, joining the EMU will not impose additional costs or constraints on the UK.

Evolution of UK / EU Government and Budget deficitsGraph no. 6

- The UK economy is already converging with that of the Euro-Zone (more than that of some pre-1999 applicants), as it can be seen in Graph 7 below6. Although further convergence could take place significant progress has been made.

- The UK already has one of the most flexible labor markets in the Euro-Zone. This will allow the UK economy to adjust quickly to future potential economic shocks even though monetary policy will be subject to ECB decisions.

- Separate economic flexibility will not be needed so much if the UK economy fully converges with the rest of the Euro-Zone and the ECB develops the experience and credibility to keep inflation low for all Euro-Zone countries. It is also important to remember that monetary sovereignty does not necessarily mean good economic performance; for instance, we can recall the example of Japan, which has its own currency and monetary policy but a sluggish economy during the last 10 years.

5 Commission Spring 2003 Forecast6 Goldman Sachs – Global Economic Paper Feb/2003


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Graph no. 8 – UK’s GDP and consumption levels

Graph no. 9 – Convergence of UK and Euro interest rates


- Moreover, the US is an example of long standing success of monetary union. Its success hinges on redistribution of resources through federal taxes and a mobile labor force willing to relocate from states with high unemployment to states with lower unemployment.

b) Why the recent growth of the UK’s economy is not related to a stronger Pound

Many people have claimed that the detachment of the British Pound from the Euro has boosted the recent growth in the UK economy. However, as we analyze the issue in greater detail, we can see that the relatively higher growth enjoyed by the UK since the establishment of the Euro has nothing to do with a stronger Pound.

In fact, the UK has been doing well recently because it has been going through a consumer-driven boom, (sharp improvement in the UK’s terms of trade, i.e., cheaper imports such as cars and clothing have boosted real household income by close to 1% a year since 1998). As it can be seen in Graph 87, consumption has been growing faster than GDP in the last few years.

We also recall that a stronger Pound generate higher purchasing power for British citizens, which in turn lead to these higher consumption levels verified in the last years.

c) Why the argument that a "one-size-fits all" interest rate can never work is wrong

The claim that the UK will suffer bad consequences from a unified interest rate with the rest of the Euro zone is unfounded, and we can cite different reasons for that:

- The UK already has a "one-size-fits-all" interest rate. Despite large differences between local economies in different parts of the UK, no one is suggesting that each region should adopt a different currency. Also, we can notice that lately interest rates in the UK and in Europe have greatly converged (see Graph 9 below8).

- Many cite Germany as a clear example of bad consequences of a unified monetary policy to a stronger economy, given the strong recession it has encountered. Yet, such recession is not mainly because of EMU monetary policy. Rather, Germany is paying the price of reunification (3% of GDP transferred to East Germany every year).

- Furthermore, future economic shocks (such as recession periods) could also be avoided if countries adopt the adequate policies in the Euro-Zone. Different action can be undertaken in order to mitigate risks of recession: firstly, is funds are transferred within the EU towards countries in recession (redistribution of resources). Secondly, if labor in other Euro-Zone countries are more flexible (mobile) to move to other countries within EU where unemployment is low.

7 Goldman Sachs – Global Economic Paper Feb/20038 Goldman Sachs – Global Economic Paper Feb/2003


Great Britain and the Euro

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