Should the UK join the EU Monetary Union?

When the single currency was introduced in 1999, eleven out of the fifteen European states joined the EMU. The UK however, one of the largest economies in the Union, declined to participate. The choice of whether or not joining the Euro zone was a fiercely contested issue in Britain with the government and business circles generally in favour of joining and the conservative opposition, right wing-media, and large parts of the public equally strong against participation.

Several key economic reasons were named for both in favour of and against adopting the Euro. The parties that were supportive of joining the EMU saw the single currency as a natural and further step towards the Single European Market. They argued that it would enhance the competitiveness of the UK economy and provide sustainable growth and prosperity. Furthermore, the government embraced a pro-European policy and wanted to lead the country out of isolation into the heart of European politics.

On the contrary, the opponents of the single currency argued that the Euro would undermine British national identity by replacing the Pound, and that Britain was culturally and economically closer to US business cycles. Their strongest argument against adopting the Euro was the loss of national sovereignty in terms of monetary policy, which would have largely been coordinated by the European Central Bank. The UK would not have been able to follow an independent exchange rate policy anymore with the result that it would have been impossible to adjust interest rates in times of crisis. The UK would have lost influence over its national economic agenda, since more and more macroeconomic decisions were planned to be made in Brussels. Additionally, while fiscal policy, like tax harmonisation, was not directly linked to the EMU, opponents believed that the adoption of the single currency and deeper integration in relation to the Single Market was a clear sign for an on-going convergence process.

In 1999, the Bank of England became independent which was generally seen as a positive signal for potential membership, since it mirrored one of the criteria, outlined in the Maastricht Treaty, for joining the Euro zone. However, there was also increasingly pressure to reject membership in the long term, when for example the Euro fell steadily against the Dollar and the Pound in the same year. As a result, the “Five Economic Tests”, issued by the Treasury in 1997 and which were key economic criteria for a potential British membership, became increasingly the breaking point of the debate. The tests addressed the following questions of concern:

1. Convergence: Are business cycles and economic structures compatible so that we and others could live comfortably with euro interest rates on a permanent basis?

2. Flexibility: If problems emerge is there sufficient flexibility to deal with them?

3. Investment: Would joining EMU create better conditions for firms making long-term decisions to invest in Britain?

4. Financial Services: What impact would entry into EMU have on the competitive position of the UK’s financial services industry, particularly the City’s wholesale markets?

5. Growth, Stability and Employment: In summary, will joining EMU promote higher growth, stability and a lasting increase in jobs?

The problem with the test were that they were originally meant to be rather elastic but increasingly became rigid hurdles for adopting the currency. Consequently, when the Treasury issued its assessment in 2003, it concluded that the five tests were either not sufficiently met or answered, and as a result British membership in the monetary union not recommendable in the foreseeable future.

There is a high risk for the UK in joining the monetary union. Strong divergences such as the high probability of asymmetric shocks and a restricted openness to trade make it less likely and favourable for the UK to join the monetary union in the near future. In contrast to the EU, there is a much closer trading relationship with the U.S. Nevertheless, some economists argue that convergence is a feature of countries that are already in monetary union; it is not something that takes place beforehand. The five criteria thus could only be accessed in the post-accession period. However, I believe that in the pre-union time a certain degree of convergence needs to be achieved first. This is currently not the case in the UK.

Under the given circumstance, the most likely future scenario is that the UK will not join the Optimum Currency Area (OCA) and will continue to keep its own currency as well as independent fiscal and monetary policy. There is still the question if the EU can be really regarded as an OCA. There are still limitations of the OCA criteria, especially in times of economic crisis and further EU enlargement.

Moreover, considering the latest economic and political developments, a membership appears to be almost impossible. The bankruptcy of the Greek state has led the Euro into its deepest crisis since its adoption in 1999. Furthermore, the change of government in the UK, with the Eurosceptic Conservatives now in power, has been equal to a kiss of death to a continuous and open debate about a potential EMU entry.  As Conservative Member of Parliament Alan Duncan said “The Euro would take UK only to economic fantasy land”.

Originally published at Julie’s Think Tank.

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