Economics in a European Context The euro © Economics Department, King’s School, Chester

Microeconomic pros and cons of euro © Economics Department, King’s School, Chester

Microeconomic pros: issues The full benefits of the Single Market can be realised Consumers benefit from: the lower prices brought about by greater competition and price transparency increased consumer surplus lower interest rates reduce the cost of borrowing lower transactions costs associated with tourism in the eurozone Producers benefit from: ability to source inputs at cheaper prices (price transparency) higher profit margins for some new market opportunities from reduced entry barriers greater levels of intra-eurozone trade greater foreign direct inward investment economies of scale from supplying an enlarged market © Economics Department, King’s School, Chester

Microeconomic pros: analysis MRuk Duk MCuk Quantity Price Dez MC1 Puk q1 Pez q3 Sez q2 © Economics Department, King’s School, Chester

Microeconomic pros: analysis Cost LRAC Quantity Dez Duk q1 C2 C2 q2 © Economics Department, King’s School, Chester

Microeconomic pros: evaluation Extent to which euro promotes competition is dependent upon: effectiveness of European Commission Competition Policy contestability of markets and barriers to entry national governments policy on state aid, for example the Single Market programme in terms of opening markets (such as energy, postal services, financial services, telecommunications) up to competition behaviour of firms in terms of restrictive practices and collusion For examples, make sure you use the ‘News’ section of the departmental website: EU row over state aid (Friday 03/05/2002) Concern over postal competition (Wednesday 01/05/2002) Single or segmented market? (Sunday 19/05/2002) © Economics Department, King’s School, Chester

Microeconomic cons: issues and evaluation There are costs in joining a single currency zone for both consumers and firms. These include the costs of changeover to the new currency: menu costs need to change accounting systems staff training costs initial lack of information on the part of consumers firms may take advantage of changeover to raise prices see website Costs of euro conversion (Monday 13/05/2002 08:22:59 AM) Not to be underestimated - some have claimed that, for the UK, this could be as much as £3.5 bn Since these costs are largely fixed they represent a heavy burden for small and medium sized firms and the retail sector in particular However, they are a one-off cost and to some extent faced by EU countries who choose to remain outside the eurozone © Economics Department, King’s School, Chester

Macroeconomic pros and cons of euro © Economics Department, King’s School, Chester

Macroeconomic pros: issues The microeconomic advantages have implications for the performance of the eurozone economy has a whole There should be higher AD in the eurozone: an expansion of trade amongst eurozone economies is an increase in eurozone consumption (price transparency, elimination of exchange rate uncertainty and reduced transactions costs) the enlarged market should attract higher levels of FDI if economies of scale raise the competitiveness of eurozone firms there should be an increase in net trade The euro should lead to an improvement in the supply side of the eurozone economy: lower costs of production greater factor mobility impact of competition on productivity © Economics Department, King’s School, Chester

Macroeconomic pros: analysis Price level Real GDP Labour AD0 LRAS0 Employment LRAS1 The consequences should be higher GDP (growth), higher employment, improved current and capital account balances without an increase in the eurozone price level. AD1 © Economics Department, King’s School, Chester

Macroeconomic cons: issues and analysis Loss of macroeconomic policy instruments interest rate is set centrally for the eurozone by the ECB and may not suit the economic circumstances of an individual country there is no longer an exchange rate for each country to compensate for differences in competitiveness greater reliance on fiscal and supply side instruments Fiscal policy is constrained by the Stability and Growth Pact PCNCR must be kept within 3% of GDP National debt must be no higher than 60% of GDP Eurozone has no mechanism for ‘fiscal transfers’ between countries There are concerns about the operation of eurozone monetary policy lack of transparency and credibility reliability of eurozone data deflationary bias caused by asymmetric inflation target © Economics Department, King’s School, Chester

Macroeconomic cons: evaluation Costs of membership are greatest when there is: a lack of economic convergence between countries countries suffer from asymmetric shocks there is a lack of labour market flexibility and mobility Loss of exchange rate policy may not be significant does nothing to address root cause of lack of competitiveness risks imported inflation may lead to ‘competitive devaluations’ is really only a shock absorber Improvement in long term economic performance unlikely unless measures are introduced to tackle supply side / productivity problems Economic convergence may take place once a country joins the single currency area it is only by joining that convergence will happen © Economics Department, King’s School, Chester

Macroeconomic cons: evaluation What is meant by economic convergence? monetary convergence measures such as inflation, budget balance and government debt for existing members additional measures for non-members include short-term interest rates and exchange rate stability real convergence economic growth and business cycle convergence employment and unemployment measures of productivity pattern and significance of extra-eurozone trade housing market structure of borrowing by both firms and consumers structure of the economy © Economics Department, King’s School, Chester

Macroeconomic cons: the eurozone evidence GDP growth rates have converged since 1999, but this can be largely attributed to the global slowdown fears that a one size monetary policy would not fit all have not materialsed convergence has been achieved by a big reduction in Ireland’s growth rate Slight convergence of eurozone inflation rates but, inflation has increased under the ECB and is above the 2% target Less disparity in unemployment rates as unemployment has fallen but eurozone unemployment remains high, esp in relation to UK and US long term unemployment remains a big problem for some economies and may be indicative of a lack of labour market flexibility Little change in productivity, with Portugal, Spain and Greece still well below the eurozone average Wide disparity in unit labour cost growth could cause some countries problems in terms of competitiveness © Economics Department, King’s School, Chester

Macroeconomic cons: the eurozone evidence Stability and Growth Pact increasingly under strain lacks the flexibility to cope with major world economic slowdowns has been criticised by Gordon Brown for its lack of distinction between current and capital expenditure (the so-called ‘Golden Rule’) Portugal and Germany are currently running deficits close to the limit and France and Italy are not far behind - fears that automatic stabilisers will not operate under such a strict fiscal regime © Economics Department, King’s School, Chester

The evidence: eurozone GDP growth © Economics Department, King’s School, Chester

The evidence: eurozone inflation © Economics Department, King’s School, Chester

The evidence: eurozone unemployment © Economics Department, King’s School, Chester

The evidence: eurozone long-term unemployment © Economics Department, King’s School, Chester

The evidence: eurozone GDP per hr worked (EU15 = 100) © Economics Department, King’s School, Chester

The evidence: eurozone ULC growth © Economics Department, King’s School, Chester

The evidence: eurozone budget balance as % of GDP © Economics Department, King’s School, Chester

The eurozone: useful links and articles Go to the department’s website news section and click on “view all previous items” Explaining Europe's low productivity - Saturday 25/05/2002 Inflation worries for the ECB - Thursday 16/05/2002 Stability and growth pact under strain - Thursday 16/05/2002 Economists defend ECB monetary policy - Saturday 27/04/2002 Other useful links on eurozone economies and the diverse economic performance of economies include: Germany’s Stability and Growth Pact problems http://www.guardian.co.uk/Archive/Article/0,4273,4346629,00.html Diverse performance of eurozone economies http://www.guardian.co.uk/Archive/Article/0,4273,4332403,00.html © Economics Department, King’s School, Chester

The UK and the euro: Government policy Current UK policy is that “in principle, the government is in favour of UK membership of EMU; in practice the economic conditions must be right” (HM Treasury, 1997) Membership is, therefore, subject to the UK passing the Treasury’s Five Economic Tests: Are business cycles and economic structures compatible so that we and others could live comfortably with euro interest rates on a permanent basis? If problems emerge is there sufficient flexibility to deal with them? Would joining EMU create better conditions for firms making long-term decisions to invest in Britain? What impact would entry into EMU have on the competitive position of the UK's financial services industry, particularly the City's wholesale markets?In summary, will joining EMU promote higher growth, stability and a lasting increase in jobs? © Economics Department, King’s School, Chester

The UK and the euro: could the UK join? Membership of the euro is also subject to the UK meeting the Maastricht convergence criteria which, adapted for the existence of the eurozone, would now be that applicants should have: an inflation rate of no more than 1.5% above the eurozone rate; long-term interest rates of no more than 2% above the eurozone rate; a national budget deficit less than 3% of GDP; a national debt less than 60% of GDP; a stable exchange rate against the euro prior to entry which would be sustainable once the exchange rate is locked in by entry into the eurozone With the possible exception of the question of the sustainability of the current £ / euro exchange rate, the UK meets the other criteria for membership and could, therefore, join © Economics Department, King’s School, Chester

The UK and the euro: convergence criteria in 2001 © Economics Department, King’s School, Chester

The UK and the euro: evaluation of membership tests Maastricht convergence criteria focus on measures of monetary convergence they tend to biased towards the success of the euro project itself rather than the interests of each individual member they do not guarantee that the benefits of membership will outweigh the costs and only provide a ‘snapshot’ at one point in time monetary convergence can occur without real convergence they do not employ the logic of optimal currency area theory Five Economic Tests are better but are, themselves, criticised: they focus on whether UK membership would be in the UK’s best interest they imply an optimal currency area framework (ie real convergence, flexibility to deal with asymmetric shocks etc) however, it is not clear that there are objective measures against which the tests can be judged (ie they are unquantified and subjective) the tests, therefore, fulfil a political function as much as an economic one © Economics Department, King’s School, Chester

The UK and the euro: should the UK join? Interest rates differentials have now converged to 0.5% points the UK “could live comfortably with euro interest rates” but whether “permanently” depends on other measures of real convergence the value of sterling against the euro is, as a result, likely to decline making membership more viable There would appear to be a good degree of business cycle convergence over a sustained period growth rates have been synchronised since 1998, although with a lag even greater convergence since 1999 in terms of peak in growth Inflation performance shows a very different picture inflation rates diverged from mid 1999 BoE has been more successful in keeping inflation low than the ECB part of the explanation lies in the depreciation of the euro and the consequent appreciation of sterling which is now abating © Economics Department, King’s School, Chester

The UK and the euro: should the UK join? Unemployment figures show a divergence, even though eurozone unemployment has fallen in 1996 eurozone unemployment was 1.4 times higher than that in the UK at the beginning of 2002 it was 1.7 times higher the UK has an increasingly ‘tight’ labour market which may require increases in interest rates some eurozone economies have significant long term unemployment, however, which means that inflationary problems emerge at higher rates of unemployment eurozone unemployment has a significant bearing on ECB monetary policy since inflationary pressures from the labour market can only be moderated by greater supply side / labour market reform evidence on the relative sizes of eurozone and UK ‘output gaps’ would help to assess whether business cycles have converged on a permanent basis © Economics Department, King’s School, Chester

The UK and the euro: should the UK join? The UK continues to have a competitiveness problem relative to the eurozone economies its productivity is much lower than the average of the eurozone economies ie GDP per hour worked in the UK is about 11% lower than in the eurozone the loss of the exchange rate as a policy instrument places greater emphasis on supply side reform to tackle relative uncompetitiveness at least by being in the eurozone, this competitiveness problem cannot be exacerbated by an appreciation of sterling as has happened since 1999 the UK is beginning to close the productivity gap, so problems are not as sever as they would have been in 1999 lack of competitiveness is also reflected in the growth in UK unit labour costs relative to the eurozone, although there would appear to be some convergence here since 1999 © Economics Department, King’s School, Chester

The UK and the euro: evidence on real convergence © Economics Department, King’s School, Chester

The UK and the euro: evidence on real convergence © Economics Department, King’s School, Chester

The UK and the euro: evidence on real convergence © Economics Department, King’s School, Chester

The UK and the euro: evidence on real convergence © Economics Department, King’s School, Chester

The UK and the euro: evidence on real convergence © Economics Department, King’s School, Chester

The UK and the euro: evidence on real convergence © Economics Department, King’s School, Chester

The UK and the eurozone: useful links and articles Go to the department’s website news section and click on “view all previous items” Euro entry could mean higher taxes - Tuesday 21/05/2002 UK productivity stuck at 2% - Thursday 09/05/2002 UK passes Five Economic Tests - Wednesday 08/05/2002 Brown stands his ground - Sunday 05/05/2002 Time to join the euro? - Friday 03/05/2002 © Economics Department, King’s School, Chester