European Business Environment - Essay Example

 «European Business Environment» The purpose of this essay is to elaborate on the decision of UK for not joining the Euro after the recent events that took place in the Euro-zone. The paper would attempt to prove whether the decision of UK was a rational one or not. To do that the paper would be divided into two sections. The first section will deal with the advantages and disadvantages for UK, or any other country for that matter, as far as joining the Euro is concerned. This section would be important as it would give the reader an idea of the advantages and disadvantages in general and it would be easier to approach the second section. The second section would give a brief description of the recent events that took place in the Euro-zone and would later deal with the relevancy of the pros and cons of joining (in the first section) to the current situation. Introduction It is surprising that UK, being a very strong member of the European Union, has still not joined the Euro even after eleven years of the introduction of the currency, as Feldstein (2010) relates. This is something that has been debatable and has attracted a lot of attention from analysts. The fact that UK still is sticking to the sterling, the currency of UK, instead of joining the Euro is both disturbing and surprising. Obviously there are reasons that are responsible for the governments of UK to have reacted that way that is to have avoided the Euro. But, according to Kelly (2010), there are many advantages too for UK joining the Euro instead of just relying on the sterling. Advantages of joining the Euro The most important, and yet the most obvious, argument given by the proponents of the use of Euro is that there might be a positive effect on the economy if Great Britain. According to Laylard et al. (2002), it is important for Britain to join the Euro because it is the easiest way for the country to improve the living standards of the people. He argues that in 1956, UK refused from joining the European Common Market. The result was that the living standards in countries like France and Germany rose greater than the living standards of Great Britain itself. The impact was such that even after twenty years of continuous economic reform, there was nothing that could be done to decrease the productivity gap that had been caused due to the delay in joining. The same is the case for joining the Euro. Joining the Euro, according to Laylard (2002) can help increase the living standards of the people of the United Kingdom. This is because a large unified market would ensure that the business is sold more widely which would in turn mean massive economies of scale enjoyed by the country. This move may also enable the common people to buy from a larger market which means that they would have a choice of many cheap suppliers. With more inflow and less outflow of money, the living standards of the people may improve considerably as they move towards a single unified market. The importance of a single market was realized by Margaret Thatcher who led to the creation of the European Single Market by removing the tariff barriers between countries. However it is very important to realize that the move towards a single market may not be complete if there are different currencies present in the ‘single’ market. With a different currency the most obvious effect would be on the producers, willing to export their products to the rest of Europe, who would not be aware of the fluctuating sterling / Euro exchange rate. The exchange rate risk may hence be a disincentive for these producers as they may not be able to predict their losses and profits as a result of the expansion of their businesses. Since 1999, many companies belonging to Britain have had problems with exporting to countries like Germany because of the high exchange rate risk. Before 1999, France and Italy faced the same problem but after their adoption of the Euro, there was no risk for the producers. The GDP of the countries that have joined the Euro has also increased considerably. In just three years that is in the year 2002, the economies of the countries that adopted the Euro prospered and the GDP growth was about 20% while the GDP of Britain remained stagnant (see Table 1). The same is true for the years that followed. Britain also has a free floating exchange rate and not a fixed one. A free floating exchange rate, as mentioned before, is detrimental to the businesses of producers who are just reliant on speculations. Figure 1 illustrates the same. The situation may worsen because, as capital becomes easier to transfer between currencies, the damaging fluctuations in the exchange rate may increase. In the period 1998-2002, Britain experienced this scenario whereby hundreds of exporting and importing companies had to suffer. The truth is that Britain is very much reliant on the International Trade. Unlike the US, the United Kingdom cannot afford to have a separate currency because the consequences would be very adverse to the economy. Right now, Britain is caught between two major currency blocs and the only way out is for Britain to accept the Euro. The adoption of Euro is also advantageous because through it. Britain can be in a better position to influence the decisions made by the members of the European Union. Representation in the European Central Bank may also earn Britain the influence over the European business cycle, as Laylard et al. (2002) state. So overall, the adoption of the Euro may help improve the living standards of people, make the British producers more competitive and earn Britain a much greater power over the matters of Europe. However it is important to realize that along being an opportunity joining of the Euro is also a threat. Disadvantages of joining the Euro The main argument that is given by the opponents of the Euro is that at any given time, it is important that the interest rates in different countries remain the same. Unfortunately this is not something that can be carried out well once the currency across countries is similar. More importantly, the European Central Bank is responsible for the setting of this interest rate. Since the ECB operates across all the member states and not just one country, it is hard to imagine that the interest rate may be set up for a particular country. This means that countries that join the Euro do not enjoy the liberty of setting up their own interest rates. There are many different situations that may arise in this condition. Obviously the exports and imports of each country are different from each other and the economies of all may not be changed or altered in the same manner. An example would be a negative shock in Britain that does not affect the rest of the Europe. Now ideally, Britain should lower the interest rate to reduce the negative shock. But if it joins the Euro, it may not be able to do so. Some people argue that the shocks that Britain might face arise from the fact that it has a floating exchange rate. Though this is not the valid scenario all the time. Britain may also experience negative shocks exogenously. As discussed before, the economy of Britain is different from other European countries and the floating exchange rates are not the only reason why there should be negative shocks. One way of dealing with shocks is to use budgetary power. Again, this kind of power is limited by the European Central Bank. The European Union’s Stability and Growth Pact requires that all member states have a budget deficit that is less than or equal to three percent. A three percent budget deficit is hard to maintain especially when the economy is suffering from a negative shock. The labour response to a negative shock in Britain is also very important. A negative shock usually results in the fall of the wages and an increase in the unemployment level. If an exogenous negative shock arises in Britain and the unemployment falls, the overall productivity falls resulting in a loss of GDP. With a different currency, the problem of the loss of the GDP may be solved by taking different measures. However this might not be so in a situation where many countries share the same currency. For Britain, this may make the situation worse off because the economic policies of the ECB might in effect be responsible for all the countries rather than a single one. Aside from the economy of Britain it is also important to note that Europe is a failing economy, for some at least. Laylard et al. (2002) argues that the unemployment rate in most of the European countries is far greater than that of Britain. Although there are exceptions like Norway and Sweden, many analysts argue that this has been the case because Norway and Sweden already had prosperous economies and lower unemployment rates. So in effect, the European Union policies have done little to deal with the unemployment problems that are faced in France and Italy. Another important argument against the joining of the Euro is that the financial system of Britain is very different from the other continental countries. Britain has a system of household finance which mainly consists of floating rate mortgages while the other countries of Europe have mostly fixed term debt. Additionally, Britain has higher levels of household debts. The consequence of all this is that the aggregate demand of Britain is more sensitive to the changes in the interest rates than any other country on the continent. As an implication, the use of a single currency is hard to manage because the same currency might be advantageous for other countries but may be detrimental to the British economy because of the changes in the finance systems. A very different, and rational, argument given by some analysts is also that the euro will fail ultimately. While people like Wyplosz (2010) might protest, the fact that the Euro has not very much achieved the objectives that it was created for. It is true that the countries of Europe are better off because they do not have to consider many different things like the exchange rates. Still, there are other complications. Euro has been weakening over the years and for many analysts it is wise for UK to not join The Euro because the depreciating Euro currency might not help with the current problems that the British economy is facing. This would be elaborated in the forthcoming section. The recent events in the Eurozone and the implications on the adoption of Euro According to a briefing report (2009), there are several scenarios that are likely to arise due to the changes in the recent events in the Eurozone. It seems that the concept of a single currency is not very popular among countries in Europe anymore. The concept of a single currency was a system that would allow similar economic circumstances for the entire Europe so that no country could benefit merely by adversely affecting the other through the exchange rate. This concept was welcomed well in 1999 when a number of countries joined in to Euro. But the circumstances have now altered. Over the past few years there has been a greater government default risk for many countries. A government default risk arises when the government of a particular country refuses to adopt measures and principles set down by the ECB. Figure 2 shows the government default risks of certain countries that rose from 2008 to 2009 as there was more incentive for the countries to move out of the economic union then to stay. A more recent example is that of Greece. In order to be a part of the Union, Greece has agreed to reduce its budgetary deficit from 14% to 4% of GDP over the next four years. As a consequence, the reduction in the government spending of Greece would require the deficit reduction to be greater than 10%. This is because the deficit reduction would cause the GDP to decline implying less tax revenue. This may be detrimental to the economy of the country. What is interesting to note here that the policies of the European Central Bank may be followed to be a member of the Union but these policies might not necessarily yield good results for countries like Greece, as a special report (2010) states. In Feldstein’s (2010), a better and ‘attractive’ alternative for a country like Greece would be to step out of the euro zone as this way it would be allowed to devalue its currency. This would help the country with a boost of the exports and a reduction in the imports. The resultant increase in the GDP would cover up for the reduction of the GDP because of the tax rise. Adopting and devaluing its own currency might also shrink the trade deficit of the country. The consequence would be that there would be lesser adverse affects on the employment levels in the country and so resources would not have to be spent on that. The recent example of Greece clearly shows how difficult it might be for a country to operate under trying to maintain a fixed exchange rate by using a similar currency. A currency affects the economy in a lot many ways and hence a fixed single currency may mean that a country is not allowed to do what is best for itself. It seems that the only purpose that the Euro zone serves here is to maintain a single currency among all countries even if the fixed nature of the currency requires huge amounts of unemployment levels in the long run. From this example, it can be said that Britain is right in not joining the Euro. This is because Britain itself has suffered immensely in the past two years. Because of the recent global financial crisis, the economy of Britain deteriorated into a liquidity crisis. The only way to deal with the issue was to increase the money supply which Britain did ultimately. If it had been a part of the Euro zone, the increase of the money supply would not have been very easy for Britain. The result would have been a greater pressure on the economy of the Great Britain. The immense pressure on the CEE states has also been a deterrent for the United Kingdom. Figure 3 shows the pressure on the currencies of the CEE states. A systematic run on the currencies of the CEE states is likely to trigger huge risks. It may create massive capital outflow in Europe and governments might find it difficult to control the short term debts that they may have to experience. Also, the crisis may travel to the Western Europe banks, as they are mainly responsible for the providing of banking services to the CEE countries. This may mean that the Euro area would be hit badly. As a consequence all of the countries that share a similar currency may be at a disadvantage as the Euro is very likely to be affected. At this time, if Britain adopts the Euro, the already deteriorating economy of Britain would be further made worse off because of the ‘dangling’ risks associated with the Euro. Both the above conditions mean that the purpose of the joining to the Euro for the betterment of the standards of living or for the increases in the productivity would not be served. Rather the producers would be made worse off because they may suffer from the inherent financial crisis. The joining of UK at this time may lead to the widening of the budget deficit and an increase in the unemployment levels of the country. Some people may argue that sterling has been falling considerably in the past few years. Especially in the last few months, the sterling has weakened a lot with respect to the American Dollar and the Euro. The weakening of the currency might be a reason why the government may adopt an alternative to joining the Euro. Nonetheless, this is not the whole truth. Because of the global financial crisis, the sterling was not the only currency that weakened. Except for the US Dollar, almost all the currencies, including the Euro, lost their market power. Now, it would be wrong to assume here that Britain would be prosperous by adopting the Euro. The fact of the matter is that the Sterling, despite the inexplicable fall, is still more powerful than the Euro currency. Hence, joining of the Euro does not necessarily provide any ‘attractive’ alternative. Conclusion To conclude, Britain’s decision of not joining the Euro has been right after the recent events in the Euro zone. The excessive amounts of budgetary deficit and the remedial measures that Greece is adopting are one example of how countries in the Eurozone are not necessarily benefiting. Also, the growing government default risks and the discomfort among countries, especially the pressures being built on the CEE countries, are not very comforting and not really attractive for a country to join in. At the time being, UK is likely to prosper more if it sticks to the floating exchange rate rather than the fixed system of the same currency. A floating exchange rate is a better and a more promising solution to the problems faced by the British economy right now. It is true that there exists a certain degree of uncertainty in the market for the producers and consumers when a floating exchange rate risk is present. But right now, UK can be more prosperous even if the risk exists, in comparison to the adoption of the Euro as an alternative. In the Euro zone, where the members themselves are not happy with the situation, it is often very hard to attract an outsider. Appendix Figures Figure 2 Figure 3 Tables References Editor. (2010). Europe: The Edge of a Full Blown Debt Crisis. US. Kanundrum Capital. EVIRA. (2009). Eurozone Meltdown. Europe. EVIRA Intelligence. Feldstein, M. (2010).The Proposer’s Opening Marks. US. The Economist, 25th August. Kelly, B. (2010). Outlook For U.S. Stocks, The Euro And British Pound. Daily Markets, 9th May. Laylard, R. Buiter, K. Huhne, C. Hutton, W. Kenen, P. and Adenen, T. (2002). Why Britain Should Join the Euro? UK. London School of Economics. Wyplosz, C. (2010). The Opposition’s Opening Remarks. US. The Economist, 25th August. Read More