The European Monetary Union is a set of trading agreements that extends a common market by adding fixed exchange rates between states in the form of a single currency.
The UK is already a member of the European Union and the European Economic Area – which has in place a common market (European Single Market) between 25 European states.
This means that the UK already experiences no tariffs or quotas between ESM trade space, and has coordinated protectionist policies with EU members for outside of the Union (for example CAP).
There are many benefits to a European Monetary Union. Firstly, it eliminates transaction costs between member states. This makes both imports and exports cheaper within the union, so the UK may be able to balance its payments more effectively. However, these only represent a small proportion of the total cost, and an even smaller proportion of GDP.
Furthermore, a monetary union will ensure price transparency across the union. This means that the same goods sold in different countries in the union will be easily comparable, and therefore information will be more symmetric. This will act in such a way to boost competition, as consumers will now be able to seek out the best deals due to the fact that they don’t have to compare exchange rates. This will also be compounded as there are no import or export duties, so prices will be almost entirely transparent – less shipping and handling charges.
Also, there will be easier trading conditions across the zone, which may benefit companies by further increasing economies of scale. However, this may be a negligible benefit due to the fact the common market is already in place, so the market was already extremely easy to penetrate. Also, further economic integration may create the ability to create firms so big that the principal-agent situation, X-inefficiently, and monopoly power may become serious issues, and diseconomies of sale might arise along with a net loss of consumer welfare. But, this may provide larger amount of revenue for the EMU governments, and perhaps the governments who control TNCs.
There will also be a potential boost to FDI in EMU countries, due to this economic potential. However, evidence suggests that this has not occurred to the extent that the EU though it would, as the UK has benefited just as much through FDI after the creation of the EMU.
The UK chancellor in 1997, Gordon Brown, created 5 economic tests that had to be met for the UK to enter the European Monetary Union. These were:
- Are the business cycles of the UK and European economies converging?
- Are the economies flexible enough to cope with external shocks?
- Will the EMU encourage FDI into the UK?
- Will joining the EMU benefit the financial services sector of the UK?
- Will joining the EMU promote higher economic growth?
As I have discussed previously, points 3 to 5 are passed by entry EMU. He said that the British and European economies were converging, but not yet fully converged, and he was worried about the flexibility of the economies. For example, in the early 1990s, Germany and the UK were in a recession while France was experiencing strong economic growth. The Brown Treasury decided points 3 to 5 would be dependant on the success of points 1 and 2.
The reason for this dependency is due to the lack of monetary control within the union. Interest rates would be set for the entire EMU, not just one country. This means that if one state is experiencing strong economic growth, while an other is recessing, monetary policy can not be changed to benefit both. Game theory may come into play, were the needs of the Union are maximised before the needs of the state. Brown was perhaps right to be worried about this, as shown by the huge financial crisis in Greece at the moment. This is caused by a huge public debt partly growing due to a large current account deficit. Deficits like these would be harder to pay off in the EMU, due to the fact that the exchange rate is floating for the entire Union instead of the state, so it would settle at a Union equilibrium which may be at odds to what the UK would desire.
So, to conclude, while there are some economic benefits to the UK’s entry into the EMU, these are somewhat outweighed, by the potential dangers due to the lack of economic cycle convergence and flexibility.