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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:
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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
Price
MCuk
MC1
Puk
Pez
Sez
Dez
Duk
MRuk
q1
q2
q3
Quantity
© Economics Department, King’s School, Chester
Microeconomic pros:
analysis
Cost
C2
LRAC
C2
Duk
q1
Dez
q2 Quantity
© Economics Department, King’s School, Chester
Microeconomic pros:
evaluation
 Extent to which euro promotes competition is dependent upon:
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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:
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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
LRAS0
AD0
LRAS1
The
consequences
should be
higher GDP
(growth),
higher
employment,
improved
current and
capital account
balances
AD1
without an
Real GDP increase in the
eurozone price
level.
Employment
Labour
© 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
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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
EUR-12
FIN
P
A
NL
L
2002
1999
I
IRL
F
E
EL
D
B
0
2
4
6
8
10
12
© Economics Department, King’s School, Chester
The evidence:
eurozone inflation
EUR-12
FIN
P
A
NL
L
2001
1999
I
IRL
F
E
EL
D
B
0
1
2
3
4
5
6
© Economics Department, King’s School, Chester
The evidence:
eurozone unemployment
E U1 2
FI N
P
A
NL
L
2001
I
1999
I RL
F
E
EL
D
B
0
5
10
15
20
© Economics Department, King’s School, Chester
The evidence:
eurozone long-term
unemployment
EU12
FIN
P
A
NL
L
2000
I
IRL
F
E
EL
D
B
0
1
2
3
4
5
6
7
© Economics Department, King’s School, Chester
The evidence:
eurozone GDP per hr worked
(EU15 = 100)
EUR-12
FIN
P
A
NL
L
2001
1999
I
IRL
F
E
EL
D
B
0
50
100
150
200
250
© Economics Department, King’s School, Chester
The evidence:
eurozone ULC growth
EUR-12
FIN
P
A
NL
L
1999
I
IRL
F
E
EL
D
B
-4
-3
-2
-1
0
1
2
© Economics Department, King’s School, Chester
The evidence:
eurozone budget balance as %
of GDP
EUR-12
FIN
P
A
NL
L
2001
I
IRL
F
E
EL
D
B
-4
-2
0
2
4
6
© 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
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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:
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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
Inflation
rate
(%)
Long-term
interest rate
(%)
Budget
balance*
(% of GDP)
National
debt*
(% of GDP)
Criteria for 2001
4.2
7.0
-3.0
60.0
Eurozone
2.7
5.0
-0.8
69.5
UK
1.3
5.0
+1.9
46.1
Source: European Central Bank
(quoted in One currency for Europe: the next steps, Nigel M. Healey, Developments in
Economics, Volume 18, Causeway Press 2002)
Note: * = figure for 2000
© 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
8
7
6
5
4
3
2
1
Jan-02
Jul-01
Jan-01
Jul-00
Jan-00
Jul-99
Jan-99
Jul-98
Jan-98
Jul-97
Jan-97
Jul-96
0
Jan-96
3 month inter-bank rate (%)
9
eurozone UK
© Economics Department, King’s School, Chester
Annualised % change in real GDP
The UK and the euro:
evidence on real convergence
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
Q11996
Q31996
Q11997
Q31997
Q11998
Q31998
Q11999
eurozone
Q31999
Q12000
Q32000
Q12001
Q32001
UK
© Economics Department, King’s School, Chester
eurozone
Jan-02
Jul-01
Jan-01
Jul-00
Jan-00
Jul-99
Jan-99
Jul-98
Jan-98
Jul-97
Jan-97
Jul-96
Jan-96
Annualised % change in index of consumer
prices
The UK and the euro:
evidence on real convergence
4
3.5
3
2.5
2
1.5
1
0.5
0
UK
© Economics Department, King’s School, Chester
Eurozone
Jan-02
Sep-01
May-01
Jan-01
Sep-00
May-00
Jan-00
Sep-99
May-99
Jan-99
Sep-98
May-98
Jan-98
Sep-97
May-97
Jan-97
Sep-96
May-96
Jan-96
Unemployment rate (% of labour force)
The UK and the euro:
evidence on real convergence
12
11
10
9
8
7
6
5
4
UK
© Economics Department, King’s School, Chester
GDP per hour worked (EU15 = 100)
The UK and the euro:
evidence on real convergence
105
103
101
99
97
95
93
91
89
87
85
1996
1997
1998
UK
1999
2000
2001
Eurozone
© Economics Department, King’s School, Chester
The UK and the euro:
evidence on real convergence
Annual % change in unit labour costs
1.5
1
0.5
0
1996
1997
1998
1999
UK
Eurozone
2000
2001
-0.5
-1
-1.5
-2
© 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”
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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