Tuesday, 19 June 2012

Anyone for the Euro?

by Peter Jordan

Protesters in Athens
Over the last few months there have been many discussions in class about the financial misfortune of the PIGS (Portugal, Ireland, Greece and Spain) and how clever the UK was to have avoided the Euro. Conversations often end by concluding that joining the Euro will never be a sensible idea for the UK. This is much the way the issue has been covered in the media.

The main reason we were fortunate not to join the Euro is that, although we have encountered similar problems to PIGS, we have been able to resolve them ourselves. This is because a main purpose of the Bank of England is to ensure that the Government always has enough money to pay off its debts. It achieves this by simply creating more money and lending it to the Government. That is why the Bank of England is referred to as the “lender of last resort”. It will lend money to the Government even if nobody else will.  This is why the financial markets are always prepared to lend money to the UK at low rates of interest.

Contrast this to the position of countries that joined the Euro and do not enjoy the benefit of a domestically controlled lender of last resort. Instead they now rely on the European Central Bank (ECB) to perform this role.  As the ECB is autonomous and answerable to all Euro members it does not provide the same level of unconditional support provided by a domestic central bank such as the Bank of England. Under the ECB, the provision of finance is neither guaranteed nor automatic, has to be approved by the other Euro members and is often subject to tough conditions.

(source: gamutnews.com)
This means that, as countries enter into financial difficulties, the markets start to sense a real risk of default (i.e. not getting back the money they have lent to governments) and so the cost of borrowing new money increases as higher interest rates have to be paid to encourage the financial markets to lend more money. At some point, the rate of interest gets so high that it makes no sense to borrow the money. This is when a bailout is needed, which is basically a loan at a lower rate of interest than you could obtain from the markets.

If the UK had joined the Euro, we might not have so easily found the £500bn to bail out our own banking system in 2008 (most people have forgotten about this) and the Bank of England would not have been able to create the £325bn it did to fund the Quantitative Easing programme, which has helped keep borrowing costs low (for consumers, businesses and government).

This means that, if we had joined the Euro, we might have found ourselves facing the same problems PIGS have, as raising this amount of finance would not have been easy without the unconditional support of the Bank of England.  Can you imagine it – being told by Germany (sorry, the EU/ECB) that there were no funds available or that, like PIGS, you can borrow money but only if you cut Government spending?

So, although not joining the Euro has been good news, this is not really for positive reasons.  
The decision has worked out well simply because we were able to borrow as much money as we needed due to the financial advantages of the Bank of England, not because our economy was in great shape because we had been able to trade more effectively outside of the Euro. Stronger trade performance without the Euro was always unlikely and there is evidence that we have missed out on some very significant economic benefits.

A recent study by McKinsey’s estimated that the cumulative benefits of the Euro to those countries participating in it was €332 bn in 2010 – equivalent to an additional 3.2% of Gross Domestic Product (known as GDP, the amount of money a country generates each year).  The benefits were derived from lower currency transaction costs (because trade within the Euro zone is conducted in the same currency), an increase in Eurozone trade,  firms becoming bigger and more competitive and higher investment and consumption due to low interest rates. However, this benefit was shared unequally, with Germany capturing 50% of this benefit – equivalent to an additional 6.6% of GDP in 2010.

The German experience is eye-catching. If the Euro captured similar benefits for the UK it would be sufficient to achieve more than twice the growth rate assumed in the Government’s deficit reduction plan. Given how critical it is for the UK to grow, we cannot afford to ignore the Euro forever, especially if the Euro emerges successfully from the current crisis and the UK’s economy continues to stagnate.

I do not feel comfortable with the narrow agenda of the Eurosceptics who focus entirely on the value of sovereignty and retaining control over currency and ignore the significant financial benefits we could capture within the Euro. There is a clear case for keeping this position under regular review, and, in my mind, it is more a case of when rather than whether the UK ultimately joins the Euro. Not in the next 2 years, but maybe within the next 10 years.

Of course we may not be competitive enough to capture the trade benefits within the Euro, but, if that is the case, then we really are in trouble.

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