UK: For Better or Worse – Tying the Economic Knot With the Euro Zone

Last Updated: 26 January 2005
Article by Rupert Lee-Browne

Rupert Lee-Browne, Managing Director at Caxton FX looks at the implications of euro entry for the UK.

We have now had over six years of the euro to assess the effects of a unified currency. The question we are now in a position to ask is – is it working as planned and what would happen if the UK was to join in the party? After all, the possibility of the UK joining the Euro would have a significant impact on the British buying French properties, not least because it would remove currency risk completely and make it easier to buy on the continent.

Before the launch of the Euro in 1999, many economists held the view that a unified currency would create stable growth for all partners. EU countries such as Germany had proved to be remarkably successful at controlling inflation, consistently maintaining lower levels than Britain. The powerful influence of the German economic model across the euro zone would, the theory went, result in lower inflation throughout the region, vital for achieving long term economic growth. Since participating countries would to be required to follow disciplined economic policies such as limits on national debt and annual budget deficits, the conditions existed to ensure stability and long-term growth across the entire euro zone.

Although countries had lost the ability to adjust interest rates, it was argued that this freedom had too often been abused in the past. Decisions had been made to suit the short-term political goals of the political party in power rather than the long-term health of the national economy. By handing control of economic policy to economic experts in the European Central Bank there was far more chance that strict policies would be followed. In any case, because of the requirements of countries to meet the convergence criteria before joining, their economies would naturally harmonize.

However, this rather utopian view has not held up in practice. Rather than witnessing a strong Germany empowering the rest of Europe, the country has been brought to its knees by unification and stands little chance of recovery for some time. In contrast, France and Spain have been doing relatively well but are now constrained by the Stability and Growth Pact that shackles growing economies. What’s more, a global trend on weakening currencies that stimulate exports for those countries has worked against those in the Eurozone – with a gradually strengthening euro, exporters have been priced out of the market.

In contrast, Britain is currently enjoying a period of sustained economic growth and stability which has been achieved by being able to adopt the economic policies appropriate to her circumstances. In particular, the setting of interest rates to a level appropriate to each phase of the economic cycle have imposed the necessary brake or impetus to keep the economy on track. By joining the single currency Britain would lose the ability to set her own interest rates and in future could have to endure rates inappropriate to her phase in the economic cycle - too high in times of recession or too low in times of boom. Since the responsibility for setting interest rates in the UK now rests in the hand of the Bank of England and not the government, the setting of rates is now dictated by longer-term economic goals, and not for political gain.

There are inherent differences between the British and Eurozone economies which suggest that euro entry would be neither prudent nor advisable. The UK economy is invariably out of phase with other European countries and it has a higher sensitivity to interest rate changes because of Britain's high proportion of mortgage owners, in particular those with variable rate mortgages. Furthermore, Britain's unemployment, public sector spending and taxation levels are markedly lower than most euro countries. In addition, high levels of pension fund assets mean that Britain is less exposed to the high levels of pension liabilities which face many other EU countries in the years to come.

The strength of the Eurozone was supposed to be guaranteed by ensuring that the economies of all the participating countries were in a healthy state and had significantly converged at the time of joining by insisting that they met strict entrance criteria. In reality most of the countries failed to meet the stipulated targets but with the exception of Greece, were allowed to join anyway due to the fudging of the convergence criteria. As a result, the inherent strength in the combined value of the Eurozone has not been forthcoming and with the introduction of ten new member states, is not guaranteed to improve. In short the U.K government will need to consider long and hard before tying the knot with euro land.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances

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