Is Eurozone sustainable for the UK to join - Literature review Example

?Is Eurozone sustainable for the UK to join? The Eurozone or the euro area can be defined as the union of countries in Europe who have decided to adopt the euro as their as a common and only currency. This economic and monetary union (EMU) currently has seventeen member countries who are Austria, Cyprus, Spain, Slovenia, Belgium, Italy, Ireland, Estonia, Greece, Germany, Portugal, Netherlands, Finland, Luxembourg, Malta, France and Slovakia. There are 10 other countries in the European Union that have not yet become members of the Eurozone. Seven of these ten countries would join once they are able to meet the strict guidelines of Eurozone. Rest of the three countries, including the United Kingdom, have an opt-out exception and will not join the Eurozone until the government takes a decision through a political referendum. Over the past few years, there has been a considerable debate about the stand that the United Kingdom has taken towards Eurozone. This study explores the topic, ‘Is Eurozone sustainable for the UK to join’. By taking a detailed look at the reasons because of which UK did not join and the reasons due to which the other countries joined, this study would try to analyze the perspective of the UK with regards to Eurozone. A Brief History of Eurozone For many decades, European leaders and diplomats have discussed and debated the concept of a monetary integration of European countries. The arguments were multiple, while some thought that the common currency could prove to be an alternative to the US dollar, some other felt that a single currency would provide many different advantages (Zimmerman, 1995). For some leaders, it meant political symbolism and for some others, it meant the rise a new and improved economic model (Vujic, 2004). After a long era of discussions and debates, the Eurozone came into existence in1999 and the Euro became the legal currency for the member nations (Kleimeier and Sander, 2002). The adoption of a single currency would mean that all the member countries would have a single monetary policy, and would not continue to have separate policies. To regulate this, the European Central Bank came into existence which lays down the Europe wide monetary policies and handles decisions related to interest rates, exchange rates and so on (Salvatore, 2002). Therefore, if any particular country wants to introduce a separate economy policy, it has to rely on the policies of the European Central Bank as it has become the sole authority of Eurozone. Having a single currency has both advantages and disadvantages and the existence of the Eurozone over the ten years has proved this. The Euro has seen success during the period of 2003-2005, where as it suffered from the loss of its stand during the economic recession that happened during 2008-2009. In recent times, there have been some apprehensions about the stability of the Euro, in the light of the results of the recession where some members of the Eurozone saw major economic crises. Why did the UK Not Join Eurozone? The United Kingdom is one of the most prominent nations of the European Union. Yet, it took a stance on not joining Eurozone. The currency of the United Kingdom continues to be pound sterling and the possibilities of its joining Eurozone look bleak in the near future (Layard, 2002). The Maastricht Treaty (The treaty on European Union) saw the negotiation of an ‘opt-out’ from the common currency (Leblond, 2004). The government that came into power post the 2010 election in the United Kingdom also decided that it would not join the Euro as long as it was in governance. In addition, the UK also has carried out many public opinion polls to take a stance on the whether it should join the Eurozone and the polls in 2005, 2008 and 2009 also demonstrated the opposition to joining the UK. The past three governments of the United Kingdom also took strong stand on not joining the Eurozone. Prime Minister Tony Blair set forth ‘five economic tests’ (tests that would help in determining criteria such as the currency flexibility and long term investment plans) should be passed before the government could move in the direction of UK joining Eurozone. In addition, the UK also had to meet the convergence criteria before being eligible to join the Eurozone (Leibbrandt, 2004). For example, the annual deficit to the GDP is higher than the norm prescribed by the euro standards. The government led by Tony Blair declared that before joining Eurozone, the United Kingdom would undergo a triple approval proposal – by the Cabinet, Parliament as well as by the citizens through a referendum. The next Prime Minister, Gordon Brown also agreed with Blair and was of the opinion that the decision on not joining the Eurozone. Post the election in 2010, the new collation government decided that UK will not join the Eurozone during the tenure of this government also. Historically, there are both economic and non economic reasons that have influenced the decision of the United Kingdom on not to join the Eurozone. In the past, it has been noticed that the currency unions have failed to succeed. One of the main arguments for not joining the Eurozone is that it would take away the ability of the United Kingdom from setting its own interest rate and this may have a negative effect on the economy of the country (Baldwin & Wyplosz, 2006). Apart from the interest rates, the country would also lose the flexibility of the currency. For example, in 2008, the devaluation of the Pound Sterling in 2008 helped the United Kingdom come out of the recession without putting a high pressure on its public (CEPR, 2009). However, in the wake of a single currency, the government would lose this power and would not be able to devaluate the currency to rescue the economy. Hence, if the circumstances are not favorable, then the countries cannot adjust the imbalances and revive the economy (Mundell, Zak and Schaeffer, 2005). Therefore, there would be no domestic monetary policy in existence that would be able to respond in a flexible manner to any economic shocks, like inflation. For some economists, the main concern is about the fact that most of the governments in Europe have a high rate of unfunded personal liabilities. Hence, the apprehension is that if the Euro is adopted, these liabilities would put a high pressure and burden on the taxpayers of the country, when a single currency is adopted (Eichengreen, 1997). Historically, the United Kingdom is considered to be a country that is much more sensitive than the other European countries to interest rate changes. This is because of the high rate of owner-occupation on variable rate mortgages in the housing market of the United Kingdom. If they join the currency union Eurozone, then it would mean that the United Kingdom should have a high rate of flexibility in both the labor market as well as the housing market (Grauwe and Mongelli, 2005). The rented housing sector is much smaller and hence, cannot be flexible enough to substitute the owner occupation sector. At present, along with the association of Bank of England, the United Kingdom has set up an effective mechanism for managing the interest rates. However, the Eurozone would mean that the controls would rest with the European Central Bank. Joining the Eurozone would also mean that there would be a very high rate of fiscal transfers among the countries to make sure that the poorer nations within the Eurozone benefit to maintain the standardization and to reduce the economic inequalities (Bradford and Lawrence 2004). The United Kingdom’s economy may not permit to afford such a high rate of fiscal transfers in the Eurozone. There are also apprehensions about the regulation of the Central European Bank (Micco, Guillermo and Stein, 2002). Even though all the member nations have adequate representation, the skeptics feel that over a period, a few nations would dominate the working of this bank and hence, the monetary policy of the Eurozone would be dictated by these particular countries. Due to all these strong reasons, the United Kingdom deliberately chose to stay away from the membership of the Eurozone, even though it is about 13 years that this common unified currency came into existence. Why did the others Join Eurozone? Even though the Eurozone came into existence in 1999 and the currency in 2001, it has a very vast history associated with it. The first indication of a European Union happened as early as 1957, when the Treaty of Rome was signed. It indicated to aspire for a close union among the people of Europe through a common market, which had the aim to create economic prosperity in Europe. This idea was further taking forward by the 1986 Single European Art. The landmark agreement happened through the Maastricht Treaty in 1992, which signaled the advent of the Economic and Monitory Unit and decided to introduce a single currency (Mojon, 2000). In the EU summit that happened in 1995, it was decided that a single monetary unit would come into existence. For a majority of the nations who have joined the European Union, the benefits of joining outweighed the minor disadvantages. For the countries of the European Union, this meant an economic standardization also. The main reason that prompted many European countries to join the Eurozone is as follows. Transaction Costs: Once the Euro comes into existence, all expenses related to transaction costs would ceases to exist and there will no longer be costs involved in currency exchanges (Bordo and Harold, 2006). This would be a great advantage for commercial enterprises and firms who have operations in the Eurozone. In addition, it will also be beneficial for the tourists as well as the tourism industry. Hence, the frictional costs that are associated with currency transactions would also reduce and can prove to be beneficial for the participating nations (Mendizabal, 2002). It was estimated that by switching to the Euro, the member countries could save as much as $30 billion every year (Salvatore, 2002). The reason for the high amount because of the reduction in transaction costs that are associated with the currency exchange by organizations that export to or export from many different nations. Prevention of Competitive Devaluation – A competitive devaluation is the process where a country devalues its currency because so that it can export more goods from the country. Many countries adopt this strategy as an attempt to revive their economy. When the currency is devaluated, the trading partners of the country also take the same step and hence, it causes a downward spiral in currency value, thereby causing a certain amount of inflation (Eudey, 1998). One of the main goals of the Economic and monetary Unit was to keep the inflation at a very low rate and thus, having a common currency made a lot of sense. Therefore, one main reason that attracted many different countries to the common currency was that competitive devaluation could be avoided. Prevention of Speculation : Speculation occurred very commonly among the member nations of the European Union. This was because the moment the news related to the fluctuation of any particular currency came out, people would try to sell their holdings in that particular currency (Di-Stefano, 2006). This would create and trend and a ripple effect. To make sure that speculation did not affect the economy, most countries had to keep a high rate of interest (Stiglitz, 2006). However, the high interest rate would pose another set of threat to the economy. To eliminate speculation, the economies of different countries would be allowed to grow in a much easier manner. Therefore, a single currency for the group of member countries would put an end to this type of speculation. Help during Economic Crisis: One of the most prominent objections related to the formation of a single currency union was that individual countries would lose their control over monetary issues and thus, would fail to bail out their respective economies. However, if a single currency comes into existence, there are certain advantages too. Each country would still have control over its fiscal policies, which means that they have the power to determine how much tax their citizens would pay (Eichengreen and Razo-Garcia, 2006). In the scenario of one country facing an economic crisis, the other country can change fiscal policies and increase the taxes so that the consumer/purchasing power of increases. This can result in surplus money, which can be used to help the country that is facing the economic crisis (Sittenfeld, 2005). However, the caveat is that if multiple countries of the union go into recession, or countries face economic crisis one after the other, then Union would not be able to help them out of the crisis. Financial Integration and International Presence: The adoption of a single currency across the Eurozone makes it much easier for the investment capital to move freely in the Euro area, especially to those particular areas where can be used in a more efficient manner (Zestos, 2005). The size of the Eurozone is large and hence, more capital is available for the investments, thus allowing the investors to spread the risks associated with the investment much more widely. Hence, the financial integration strengthens the union. Similarly, the Euro has a stronger presence when compared to the individual currencies of the different countries of the smaller European countries in the international markets. As Euro has become the second most important currency in the world after the US dollar, the Eurozone has a much stronger voice in the world economy (Thurow, 2003). Benefit for the Consumers: Another very prominent advantage of a single currency is for the consumers or the common public who live in the Eurozone. The single currency keeps inflation in check because of the higher competition. This increases the affordability of the consumers (Stone and Bhundia, 2004). For the consumers, the process of borrowing is much easier and cheaper because of the acts of the European Central Bank. In addition, it is also easier for the citizens to travel across the regions with the common currency, without carrying out any currency exchange. Single Currency Stability One of the main goals of the Eurozone was to establish stability in terms of interest rates and currency fluctuations for the member countries (Kleimeier and Sander, 2002). However, its stability has been put to test several times in the past 13 years that it has come into existence. The most critical test for the stability of Euro happened after the recession began to hit the European Markets during the late 2007 to early 2008. During a global economic recession, the first step for every government is to cut the interest rate, so that the domestic spending increases and thereby, the exports also increase (Steil and Litan, 2006). However, the members of the Eurozone do not have this option in front of them. The control of the interest rate has been given to the European central Bank, which is remotely located. Therefore, the governments of the 16 governments of the members felt under intense pressure to boost their economies (Ferrara, 2006). During the phase of recession, the ECB tried to help out the member nations by reducing the interest rate to 2% so that the Euro would fall against the dollar (European Economy, 2009). However, for many of the members of the Eurozone such as Greece and Ireland, the interest rate of 2% was very high when the economic situation was taken into perspective. In addition, the ECB also faces a very unique challenge because the interest rates would prove to be beneficial to some of the members, but also can cause damage to some other economies (Bagus, 2011). For example, the unemployment rate for a country like Austria was much lower than that of Spain. Subjecting these both economies to the same interest rate can prove to be disastrous for at least one of the countries. Therefore, the additional challenge that Eurozone faces is how a single standard interest rate can be applied in such a way that countries that have different fiscal policies benefit from it. This was put to test through the economic recession. Many skeptics also speculated that nations like Greece, who suffered immensely, should consider moving out of the Euro. According to the Maastricht treaty, if a particular country decided to leave the convergence, there is no legal mechanism. However, if the government of any country decided to leave it, then there is no way that it can be stopped. Hence, the stability of the Euro has been a big concern for the members of the Eurozone (De Grauwe, 2005). Economists all across the world have speculated the stability of Euro right from the time it came into existence. In 2000, the Euro had declined in value considerably against its key opponents – 25% against the dollar, 20% against the Japanese Yen and 13% against the British Pound Sterling (Singer, 2002). There were many theories that tried to explain this drop, from the real interest rate differentials, to the euro being undervalued, to the structural weakness of the Eurozone and to just plain bad luck ( Posen, 2005). To make the Euro strong and stable, the ECB has come out with a bailout plan known as the European Stability Mechanism, which would have a lending capacity of €500 billion for its member nations (Coenen, Straub, and Trabandt, 2011). The amount would be divided among the member countries over a period of next five years. The success of this plan would be evident only once they get implemented. However, it is also necessary to understand that this huge bailout measure would be successful only if the economy also presents favorable conditions. Economic Scenario in Greece and Italy During the Economic recession that expanded over the years 2008-2010, the European economy plunged and Greece and Italy saw severe economic crisis, which has put the Eurozone in crisis also. The scenario of the economic crisis that is being faced by Greece is what is called the ‘classic sovereign debt’. Greece had gotten into a very high level of debt even before the economic crisis began, during the time when the capital markets were highly liquid. After the economic crisis began, the capital markets took a turn and became illiquid, which resulted in the situation where Greece was not be able to roll-over the debt obligations that it already had. To help the economy from going into a situation of default, the government of Greece began some internal austerity measures and also requested help from the Eurozone and the International Monetary Fund (Willis, 2010). After the new elected government came into existence in 2009 and the changes in the GPD estimates, Greek bonds got downward ratings by three major credit ratings agencies (Nelson et al, 2010). Furthermore, in early 2010, Eurostat released its estimate of Greece budget deficit, causing further panic among the investors and worsening the economic crisis. There are many reasons for the economic crisis in Greece, such as a high spending government, low revenues, high wages and relatively low productivity and so on. Another main reason is considered to be the increased access to capital at low interest rates. After joining the Euozone, Greece shared the common monitory policy that was managed by the ECB. Due to this, the investors developed a higher level of confidence on the members and allowed Greece to borrow a more favourable interest rate. Therefore, the critics feel that this artificially cheap credit resulted in such a high level of debt for Greece. In addition, the European Union also did not enforce the Stability and Growth pact that would prevent this debt situation. Italy, one of the most prominent members of the Eurozone also underwent a similar crisis during the recession, catapulting the country into severe economic crisis. The country could not take steps related to economic reforms because of the cessation to the Central European Bank and it could not modify its fiscal policies because of the large debt that it was in. According to the research done by Eurostat, the budget deficit ratio was the second higher, after Greece. This was indication enough to show that the economy of Italy was not trending in the right direction. The government moved into an aggressive mode and introduced austerity mode to revive the struggling economy. However, when compared to Greece, Italy was in a much better situation. In Italy, the public debit is largely owned by its national subjects (Daveri and Jona-Lasinio 2006.). In addition, it also has a high level of private saving and low level of private debt. This creates a better situation and improves the chances of the revival. Even though Italy was much better off when compared to many of its European and international counterparts, it indicated a strong sign in terms of the Euro. A strong economy and a prominent member of the Eurozone such as Italy, landing up in a high debt, signalled the weakness of the Euro and many economists even suspected that this could be an indication of the disintegration of common currency. The disadvantages of having a single currency and no control over the interest rates became much more evident after the economic crisis in Europe. Will it be stable for UK to join? One of the most speculated topics among the economists is whether it would be sustainable for the United Kingdom to join the Eurozone and adopt the common currency like its neighbors. Post the economic crisis, the speculations have increased about the stability or the lack of it, in case the United Kingdom becomes a member of the European Union. The United Kingdom was one of the first countries to overcome the economic crisis because it took the necessary steps to lower interest rates. This flexibility would go down if the United Kingdom adopts the Euro as its currency. It would be dependent on the ECB for any form of economic revival. This can result in crisis situation, where the government would not be able to take much action to revive the economy. Hence, this argument questions the sustainability of the Eurozone for the United Kingdom to join. Another issue related to the sustainability of the Eurozone in case the United Kingdom joins is the issue of convergence. The United Kingdom has a past history of divergence, and has shown significant difference when compared to the Eurozone, in some particular sectors such as the housing sector (Singh, 2000). Because of this structural incompatibility as well as dynamic changes, it is not certain whether the business cycles of the United Kingdom are compatible with that of the Eurozone. While the United Kingdom has become more convergent as the time has passed by, it has still not reached the stage where stability can be assured. In addition to the convergence, another factor that needs attention is the flexibility. In case problems emerge, is there enough flexibility to deal with the issues. In the United Kingdom, progress has been made in the field of flexibility in labor, capital as well as product markets. However, more steps need to be taken so that the economy of the United Kingdom becomes resilient and strong enough to deal with potential risks. For example, at times, inflation becomes volatile and greater flexibility is needed throughout the Eurozone to minimize the effects of this high inflation. While joining the Eurozone on one hand would provide the United Kingdom with a higher boost in the financial services industry, additional revenues by eliminating the transaction charges, more jobs and financial integration with its fellow European Union members, sustainability cannot be assured until there is the right level of converges and flexibility (Leonard et al, 2005). Therefore, for sustainability and stability, the United Kingdom should take the bold step of joining the Eurozone only after more progress has been made in the direction of both convergence as well as flexibility. Conclusion Through the decade long history of Euro, it has become evident that Eurozone offers both key advantages and some very prominent disadvantages to it also. Hence, joining the Eurozone would not guarantee stability. In addition, it was also noticed that when a global economic crisis happens, the members who had adopted the common currency faced the crisis in a very severe manner because they could not adjust the interest rate to bail out the economy. Hence, for the United Kingdom, the debate regarding joining the Eurozone is a difficult and speculative one. The scholars have divided opinion regarding this issue because of the difficulty in predicting the consequences of the membership of the United Kingdom in the Eurozone. References Bagus.P., 2010., The Tragedy of the Euro. Ludwig Von Mises Institute. [Online] Available at: http://mises.org/books/bagus_tragedy_of_euro.pdf [Accessed 25 July 2011] Baldwin, R & Wyplosz C., 2006. The Economics of European Integration. New York: McGrawHill Bradford. S. and Lawrence R. Z., 2004. Has Globalization Gone Far Enough? The Costs of Fragmented Markets. Washington D. C : Institute for International Economics Press Bordo, M and Harold. 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