Volume 2 No 2 - 1998
THE EUROPEAN COMMON CURRENCY
F.R. Oliver
Department of Economics, University of
Exeter
Eleven out of the fifteen member states of the European Union are in the process of adopting a common currency, the euro, and phasing out their national currencies (pesetas, lire, francs etc.). The remaining four are Denmark, Greece, Sweden, and the United Kingdom. The United Kingdom is thus the only major member state which is not changing its currency at this time. The eleven joining countries have satisfied "convergence criteria" embodied in the Maastricht Treaty, requiring sound public finances and low inflation and interest rates. These criteria ensure that their economies are sufficiently similar to make a common currency feasible. A number of the eleven countries had some difficulty in meeting the criteria and had to take drastic action, for example by raising taxes and cutting public expenditure, in order to do so. Italy had perhaps the greatest difficulty in doing so, and its success pleasantly surprised many outside observers who had been expecting a rather smaller number of countries to join the economic and monetary union (EMU) in the first wave. The eagerness of many countries to join the common currency in the first wave was a highly effective stimulus to them to bring their economies and national finances under firm and belated control. It is ironic that the United Kingdom, which would easily have met the criteria apart from previous membership of the exchange rate mechanism, chose not to join at the beginning of the euro.
The new currency comes into being on 1 January 1999 in paper form as a unit of account, and there will be an adjustment period of three years before actual notes and coins circulate from 1 January 2002. For six months euro notes and coins will circulate together with national currencies while the latter are being phased out. Our experience of decimalisation strongly suggests that the new currency will largely replace the old in a matter of days. During the three transition years, national currencies will represent fixed amounts of euros, so that, for example, 1FF can be treated as a 16c coin.
The smoothness of decimalisation in the UK was largely the result of extensive planning for years in advance, and the eleven countries have been planning similarly for the introduction of the euro. Some British opponents of the common currency hoped that it would never take effect even in other countries, and many UK firms underrated its probable effects on their businesses even while we remain outside. The result is that little of the necessary planning has taken place in the UK, partly as a result of uncertainty as to whether and when we were going to adopt the euro, so there is bound to be some appreciable delay following a decision to join.
It was at the Maastricht Conference that the heads of government of the 15 agreed that it was absurd, inefficient and divisive that in a common market there should be 14 different currencies (Belgium and Luxembourg already shared a currency). In order to achieve the greatest economies of scale and to minimise currency exchange costs and uncertainties a common currency would be adopted throughout those EU countries, which were ready for it in economic terms. John Major negotiated a British opt-out, whereby the United Kingdom could decide at a later stage whether or not to join. This agreement, like so much else associated with the European Union, in part reflected the ideal of the countries of Europe coming ever-closer in peace and friendship while maintaining their independence, and in part a wish for enhanced economic prosperity through greater economic efficiency. The decision to adopt a common currency was, and is, opposed by many, especially perhaps in the United Kingdom, on both bases - that it represents a further weakening of national sovereignty to the benefit of remote and undemocratic bankers and bureaucrats, and that it will be economically disadvantageous in limiting individual governments' powers of economic management, for example by ruling out devaluations of national currencies.
The Maastricht Treaty was signed in February 1992 and ratified by the United Kingdom in July 1993. In the General Election of 1992 an overwhelming majority of voters supported pro-Maastricht candidates and a similarly overwhelming number of pro-Maastricht MPs were elected.
Planning for the introduction of the euro, both in the eleven initially-participating countries and the remaining four, who will nevertheless be closely affected by it, has thus taken almost seven years. Governments, businesses, financial institutions and individuals have had to prepare accordingly. A trouble-free transition largely depends on the success of this preparation. It is unfortunate that the political and parliamentary difficulties of the Major administration so severely inhibited such advance planning in the United Kingdom.
The UK will have to decide when, or indeed whether, to join the common currency, necessarily at a later stage and after a referendum. Those with strong 'pro' or 'anti' emotions and prejudices are unlikely to be convinced by rational argument but there is a large body of undecided opinion which will be guided by the success or otherwise of the common currency among those adopting it and our practical experience of staying out. Public opinion was initially extremely hostile towards membership of the common market, but by the time of the 1975 referendum it had come round to remaining in it as a result of noting its success. The UK voted by 2-to-1 to stay in, and crushingly defeated the Labour Party in the General Election of 1983 when its manifesto pledged a UK withdrawal, the only time that an established political party has advocated this.
One might discuss at length whether a common currency is a good thing or a bad thing in some abstract sense and whether or not the eleven countries of "Euroland" are well advised to adopt it, but that is not the question facing the United Kingdom now. The euro is going ahead without our participation in the first wave; the relevant question for us is, given that it is being established, should the UK participate?
John Major's "wait-and-see" policy had the advantage that, as UK participation had not been ruled out, British negotiators could and did participate fully in setting up the euro and establishing conditions for its operation. On the other hand, it made it impossible to argue that the European Central Bank (ECB) should be sited in London. The City of London is a source of great wealth and well-paid employment to the United Kingdom, being, with New York and Tokyo, one of the world's three main financial centres. The "square mile" alone provides about 250,000 jobs. In 1997 United Kingdom exports of services by the financial sector were worth £13.8bn and net investment income of financial institutions another £11.4bn (British Invisibles press release, 16 October 1998). But London is in keen competition with Frankfurt, where the ECB is being situated to the great advantage of Germany and the great loss to London, and with Paris and other cities. A similar, more recent, result of the UK's loss of influence as a result of not joining in the first wave relates to the design of euro banknotes. Trivially to many people, it was decided in the absence of British negotiators that national symbols such as the Queen's head should not appear on euro notes. British failure to join the common market initially did not prevent its establishment - it merely meant that its operations were geared to the needs of its participants and had to be largely accepted by the UK when it joined. History is repeating itself regarding the common currency, its institutions and its operation. Over-anxiety about the forms of sovereignty has led to a loss of effective influence.
Given that the common currency is being adopted throughout most of the EU, the UK has to decide whether and when to join. Despite a lack of unanimity in their ranks, the general view of the Confederation of British Industry, the Trades Union Congress and the National Farmers Union is that the UK should seek membership at a suitable opportunity in the fairly near future. This attitude is based on the understanding by these bodies of the economic needs of their members.
A notable contribution to informed discussion was a paper by David Currie (The pros and cons of EMU, HM Treasury, 1997), an updated summary of an earlier report published by the Economist Intelligence Unit. (Single copies are available from HM Treasury, telephone 0171 270 4860.) This was published to stimulate and inform public debate, but is fairly heavy going to those unfamiliar with economics and economic affairs. "[David Currie's] position on EMU is best described as that of the 'sceptical pro', sympathetic to the EMU project but acknowledging the risks." (p. 21)
For private individuals, there would be considerable practical advantages in UK participation. There would be no need to obtain foreign currency in advance of going abroad or to worry about modest sums left over on returning home. The saving in convenience would be paralleled by saving the costs of exchanging money, so foreign travel would be made rather easier - no more difficult than going to Scotland from England or vice versa. Prices in foreign shops would be more readily comprehensible. These advantages would help the UK holiday trade; for example, while the UK is outside Euroland, French travellers will find it simpler to go to Spain on holiday than to come here and will avoid currency transaction costs in doing so, to the detriment of our holiday industry. On the other hand, a common currency might induce more British holiday-makers to go to Euroland rather than to UK resorts.
Even before the UK joins, it is expected that euros will circulate quite widely in Britain, particularly in areas visited by travellers from overseas. Some British shops are making arrangements to accept euros as well as sterling, and competitive forces will encourage this.
Membership would make it much easier for UK residents to buy from abroad, by sending cheques in euros. In any case, it will be possible to run bank accounts or take out mortgages in euros. Mortgage and other interest rates in euros are likely to be rather lower than in sterling because of the risk of devaluation of the pound; this risk is likely to make euro mortgages risky and unattractive to UK citizens unless their incomes are denominated in euros (perhaps because they work overseas). Since 1945 the UK has had a comparatively high rate of inflation, leading to periodic devaluations. Thus, in 1957 a pound was worth 11.72 deutchmarks; forty years later it was worth only 2.84 (Economic Trends Annual Supplement 1997 and Economic Trends August 1998). The option of running a high-inflation economy would not be open given a common currency, and any devaluation would be of the euro against other currencies, such as the dollar and the yen.
A common currency ensures transparency of pricing. That is, it will be apparent at a glance in which countries particular goods are especially cheap or especially expensive, enabling purchasers to act accordingly. For example, it is notorious that new car prices are substantially higher in the United Kingdom than in most other EU countries, but the extent of this is concealed by the variety of currencies in which they are expressed. Thus it can be expected that strengthened competition among sellers will check rising prices.
As stated, the great majority of UK businesses are in favour of membership in principle. Many industrial businesses use parts and/or raw materials imported from the participating countries, and most seek to export some of their output to those countries. They are faced with the same problems and costs as are private individuals. If the pound weakens or is devalued, goods from overseas priced in marks, say, become suddenly more expensive. If on the other hand the pound strengthens, overseas customers are faced with higher prices in their own currency, reducing demand for British exports. It is possible to hedge against many effects of currency fluctuations, but at a cost which rises as the risk of such fluctuations rises. Even without any changes in exchange rates, the transaction costs of converting foreign money into and out of sterling are a burden on UK firms which will be largely avoided by competitors within the common currency area.
For the last several years the pound has been markedly overvalued as compared with foreign currencies. This has had a most serious effect on the competitiveness of British industry. A common currency would make this impossible as regards trade within Euroland, and the dominance of the euro in world trade would make it less likely regarding other trade. It is, however, essential that, in adopting the euro, a sensible exchange rate should be used. Britain was forced out of the exchange rate mechanism in 1992 because we had joined at an unsustainably-high exchange rate, having been carried away by nationalistic but misplaced enthusiasm for a "strong pound". The danger of a recurrence of an over-strong pound will continue to threaten British industry until and unless we adopt the common currency.
In addition, UK businesses are faced with higher interest rates than their competitors elsewhere in the EU. To some extent these reflect the Monetary Policy Committee's judgement that high rates are necessary to control UK inflation (which would otherwise need to be achieved by higher taxes), but they also reflect the UK's post-war history of relatively high rates of inflation and the steady decline in the value of sterling in terms of some foreign currencies.
It is difficult to overstate the importance of the export trade in goods to the UK economy, and hence the need to maintain its competitiveness. Total exports of goods in 1997 were £170,145m, of which £94,532m (55.6%) was to other countries in the EU, including £87,073m (51.2%) to Euroland. These amounts constitute significant shares of the Gross Domestic Product at factor cost, £677,390m - 25.1%, 14.0% and 12.9% respectively. Total imports of goods were £183,124m, of which £99,595m were from the EU and £92,229m from Euroland in particular. (Data from Monthly Digest of Statistics, August 1998 and United Kingdom National Accounts, 1998 edn, p33). Equivalent data relating to trade in services in 1997 have not been published at the time of writing, but in recent years it has amounted to about a third or a quarter of trade in goods, with a substantial surplus and a smaller share going to the EU. It is thus of the greatest importance that UK manufacturers should not be put at a competitive disadvantage as a result of currency transaction costs and uncertainties and high interest rates.
Much manufacturing is undertaken by large, in many cases multinational, companies. The location of such investment is determined by numerous influences, of which the development of the EU from the original common market is notable. Membership of the EU has been highly successful for the UK in enabling it to attract a disproportionate share of investment, from UK firms, from other EU firms, and from overseas firms. Such investment is sited within the UK with the intention of selling the output within the common market, but the UK is in competition with the other countries of the EU for such investment. The success of the EU as a whole in attracting such investment has been strengthened by the evolution of the Single Market Programme in the late 1980s. Within the EU, the UK has been especially successful; the universality of the English language, the construction of the Channel Tunnel, and good British labour relations in recent years have been among the causes of this, which has shown itself conspicuously in the motor industry, with French and Japanese manufacturers siting their plants here. The direct foreign investment into the UK has been above-averagely labour intensive, that is good for jobs. On the other hand, UK firms can and do undertake such direct foreign investment in other countries, within the EU and elsewhere, and can be expected to increase this while we are outside the common currency area in order to control costs and avoid exchange rate uncertainties. The widespread expectation that it is merely a matter of time before the UK joins the common currency has limited the harm done by our failure to join in the first wave, but it can be expected that the longer we maintain a separate currency the costs that this imposes on UK manufacturing will cause more new investment to be sited in Euroland while competing UK plants (e.g. in the semiconductor industry) close. This has been confirmed by a study by the National Institute for Economic and Social Research (Observer, 27 April 1997).
Membership of the common currency would undoubtedly restrict the freedom of United Kingdom economic authorities, for example in setting interest rates and in devaluing the UK currency. It is sometimes suggested that economic conditions in the UK may differ so much from those in the rest of Euroland that quite different economic policies may be desirable here. It is not clear that these are, in practice, substantial arguments, given that the convergence criteria have been met. In the absence of tight exchange controls interest rates are largely determined by international market forces, and the scope for individual countries to get out of line is quite limited. Devaluation is usually the consequence of higher inflation rates, and it may well be to the advantage of the UK to have lower rates in future, whether or not we are members of the common currency. It may be more advantageous for us to influence interest rates throughout Euroland through our membership of the common currency and ECB than to appear to control them in this country alone, the more so since so substantial a part of the UK economy is dependent on exports to Euroland. (There is some real disagreement between the German view that the European Central Bank should use its powers strictly to achieve currency stability and the French view that wider considerations of economic policy, such as reducing unemployment, should have a greater influence. Decisions on such matters will be made without regard to British views and interests unless and until we join. The change of government in Germany following the election in September 1998 may lead to a modification of the German approach.) It will in any case be necessary for the ECB to establish a reputation for prudence and efficiency, as the Bundesbank so notably has.
Given that the UK economy is so dependent upon that of the rest of the EU, it might be more advantageous to us, and enhance our effective rather than nominal sovereignty, to have an active role in managing the euro through membership of the appropriate inter-governmental committees and the Board of the European Central Bank rather than have a nominally independent currency but be obliged to accord with the decisions and policies of others.
The lower interest rates which would follow UK membership would enable a substantial reduction in public expenditure as government and local authority debt came to be refinanced.
It is a feature of the arrangements that individual countries limit their fiscal deficits to 3% of Gross Domestic Product. Such limits would not at present impinge on the United Kingdom, but might prevent governments in the future maintaining or increasing public expenditure faced with falling revenues in a recession. They would not restrict individual nations from adopting high-tax-high spending or low-tax-low-spending policies as they think proper.
Within a country with its own currency, workers can and do move freely to where jobs are available and where wages are highest (which is where the work force is likely to be most productive). Language and cultural difficulties will inhibit such movement within Euroland. However, it is notable that many UK nationals do, in fact, work in other EU countries, where their professional qualifications are recognised. Significant numbers of British construction workers, for example, are employed at high wages in Germany. In any case, it is not clear that exchange rate flexibility is of much practical value.
Various superstitions and scare scenarios surround the common currency. Countries are not accepting responsibility for others' liabilities, for example pensions. The ECB's reserves will be provided by participating countries, but will remain among the assets of those countries; the ECB is not a plot to seize UK gold reserves by subterfuge or otherwise. The transition costs are sometimes wildly exaggerated; there would certainly be costs involved in changing our currency, for example in printing the new banknotes, but these costs could be minimised by advance planning, for example in ensuring that new cash registers, computer systems, etc. as they are acquired and installed are euro-compatible. Many British companies, especially those trading extensively overseas, are doing just this, but the continuing uncertainty regarding our membership is inhibiting such advance planning. The total costs of changing would be manageable as one-off expenditure; a figure of £2.5bn has been suggested. Ever since the United Kingdom joined the (then) Common Market, absurd stories have circulated, often in the tabloid press, about some exotic heavy-handed interference from "Brussels". By the time such stories have been clarified or disproved the media have lost interest in them and the public remain misinformed. It can be confidently predicted that such stories regarding the common currency and the ECB will circulate with increasing frequency as our membership comes closer, and that most of them will be false.
There may well be a case for not rushing into immediate membership, in case the whole project collapses in tears for some unforeseen reason. Indeed, as a result of procrastination by the Major government, some delay in joining is now unavoidable. Further, our membership is dependent on the result of a referendum, the holding of which will take some months to arrange. The referendum may possibly be held in the autumn of 2001, with membership taking effect a year or two later. Economic forces will not remain in abeyance while the UK dithers; manufacturing investment is already going elsewhere. It is increasingly clear that unless the practical experience of our eleven neighbours and partners shows up major unforeseen disadvantages of the common currency, economic forces will compel British membership in the fairly near future1.
1. The author is indebted to several colleagues and others for advice and help in preparing this paper.
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