I made a short video on some of the problems facing Greek economy and Euro below. Recently, the EU and Germany have been making suggestions that they will offer Greece a bailout – to protect the value of the Euro (see: Telegraph article). However, I’m sure any bailout will have strict measures for Greece to reduce their budget deficit. The Greek economy still faces many deflationary pressures. The end of the fiscal crisis will not be the end of their problems.
The cost of bailing out the Greek debt is very small for the EU. The more significant issue is the precedent the EU are taking in bailing out countries who have large debts. It shows that in Monetary Union, there is a need for countries to maintain fiscal responsibility – otherwise the whole currency will be effected.
The Euro was introduced in 1999 to great fanfare. It is a bold economic plan to encourage greater convergence and reduce transaction costs within the European Union. As a frequent traveller to Europe I am frequently grateful countries have adopted the Euro as it makes it much cheaper to need just one currency.
However, the impact of the Euro on the wider economy is more contentious. These are some of the essays I have written on the Euro. As you will see, I find it hard to see a good reason for UK to join. I don’t have any ideological opposition. But, with the UK sensitive to interest rates, I feel the common monetary policy would only exacerbate the UK’s economic difficulties. Let us just hope, the UK doesn’t go bankrupt and have to go begging to be admitted into the Euro…
The Pound Sterling has many factors which are causing it to be weak on the exchange rate markets. However, in recent weeks, the prospect for the Pound has improved somewhat. These are the factors which will influence the future value of the Pound.
Factors which Influence Pound
Low Interest Rates. When UK interest rates are low, it is less attractive to hold Savings in UK banks. Therefore, there are less hot money flows into the UK. The sharp drop in UK interest rates from 5% to 0.5% has made the UK a less attractive place to hold savings so the value has gone down.
However, the ECB are slowly realising they also need to cut interest rates very low. The ECB is more cautious about inflation, but, ECB rates are edging down towards UK rates making the Eurozone area less attractive to hold savings in. If the Eurozone experiences a prolonged recession, even the ECB may pursue a zero interest rate policy. This would strengthen the Pound relative to Euro
Finance Sector hit hard. The nature of the credit crunch has hit the UK economy hard because of our exposure to the finance sector. Also falling house prices in the UK are causing a prolonged recession.
However, there are signs of increased weakness in the Eurozone economy. Germany has a forecast of -6% for GDP. This is because they rely on exports which are falling due to global downturn. A deeper recession in the Eurozone increases the likelyhood of low Eurozone rates and this will weaken the Euro.
Quantitative Easing. The UK has embraced quantitative easing and is effectively increasing the money supply. This increases the chance of inflation and therefore a reduction in the value of the exchange rate. The ECB (heavily influenced by the German anti-inflation sentiment) are much more reluctant to embrace an increase in the money supply. This has stregthened the Euro.
However, the fact the UK is pursuing quantiative easing increases the chance of a quick recovery and a rise in interest rates to deal with the inflationary pressure. Therefore, this prospect of a rise in UK interest rates could increase the value of the Pound. It is likely UK rates will rise before ECB rates.
Government Borrowing. The size of UK government borrowing and the forecasts of a rise in public sector debt as a % of GDP has worried markets. There is a fear that this could be inflationary and even the UK could lose its high credit rating in the future. This would weaken the Pound against the Euro.
However, the UK is not alone in having an increase in government borrowing. There are many European countries with a national debt which as a % of GDP is larger.
Fair Value of the Pound to Euro.
With a Pound = 1.1 Euros, items on the continent seem expensive (except alcohol, petrol and cigarettes). Places like Spain and Greece are no longer cheap for the British tourist. A fairer value may be closer to 1.2 Euros. (However, this is very subjective and purchasing power parity values often don’t influence exchange rates in short term)
The UK economy was initially hit hardest by great depression. But, the combination of quantitative easing, zero interest rates and large government borrowing means it is likely to recover sooner than the Eurozone economy which looks increasingly grim. This points to a tentative rise in the value of the Pound, unless the UK were to experience a double dip downturn.
National Debt and bond yield spread: Source: Economist
Since the financial crisis the bond yields in many European countries have diverged.
For example, in Greece which has government borrowing of over 100% of GDP, bond yields are now 2.5% higher than German bond yields.
The higher bond yields on Greek debt reflects the fact, investors are more nervous about buying Greek bonds because of the greater possibility of debt default.
Note in these statistics from Economist, Irish government borrowing is only 25% of GDP, but since 2007 Irish borrowing has increased sharply because of recession and bank bailouts.
Quantitative Easing in Eurozone
Suppose the ECB wanted to pursue quantitative easing in the Eurozone; this would involve buying government bonds to drive down long term interest rates. Clearly it would be a great boon for Greece if the ECB bought their government bonds; the yields would decrease, people would have more confidence in Greek debt and the inflationary impact of expanding the money supply would be limited by the size of the ECB and other countries fiscal restraint.
You can see how politically sensitive it would be for the ECB to decide which government bonds to buy. Do they buy bonds in countries with the highest interest rates, or do they have to buy bonds equally in all countries. Unsurprisingly the ECB is trying desperately hard to avoid even contemplating this unorthodox monetary policy.
Suppose Greece experiences rising wages and rising prices. Greek goods become relatively uncompetitive in the Eurozone, therefore it will struggle to export and Greeks will buy more imports.
If they had a floating exchange rate, the Greek currency would depreciate and they would regain competitiveness through the exchange rate. But, in the Euro, they can’t do this.
Therefore, this puts increased pressure on the Greeks to reduce costs and inflation to regain competitiveness.
The advantage is that being in the Euro gives stronger incentives to retain competitiveness and keep inflation low.
The disadvantage is that if you struggle to keep inflation low the economy will suffer. Also you cannot depreciate the currency to improve the current account deficit.
For example Greece has a chronic balance of payments deficit. In 2008, the current account deficit was 13.5% of GDP. (source: Economist fact file Greece)
A similar problem is faced by Spain who has a current account deficit of 8% of GDP.
The problem is that it would be very difficult to force through wage cuts to improve competitiveness.
It’s a tough time for the Greek and Spanish economy.
There was a time when joining the Euro was a big issue. Recently, it seems to have slipped from the public’s attention, and there seems little enthusiasm for joining. For quite a few years opponents could argue, with good reason that the UK economy was doing very well without being a member. However, since the economic slowdown, I have had a few people asking me whether it is now a good idea for the UK to join.
I would argue that a recession makes it even less desirable for the UK to join.
Firstly, whatever problems the UK has, they are not caused by having its own currency. The Euro economy is also entering a recession.
Secondly, in a recession, it is vitally important the UK is able to have independence over its monetary policy and cut interest rates if necessary.
The major disadvantage of joining the Euro is that the UK is required to have a common monetary policy. In other words UK interest rates will be set by the ECB depending on what the ECB think is good for the whole Eurozone area.
This means that ECB interest rates may be unsuitable for the UK economy. For example, if the Euro economy recovers before the UK economy, interest rates may increase too quickly and harm the UK’s recovery.
The nature of the UK housing market also means that the UK is very sensitive to interest rates. In the UK, many have high variable mortgages. This means a small increase in interest rates has a big effect on consumer spending. Therefore, it is even more important that interest rates are not unsuitable for the UK economy.
If interest rates are wrong it can either cause an inflationary boom (or house price boom) or a deeper recession. These potential negative effects mean that any small advantages of lower transaction costs are easily outweighed.
Readers Question: ‘Outline two reasons why the UK’s housing market represents a barrier to the UK’s membership of the euro’.
Joining the Euro involves a common monetary policy. This means that UK interest rates will be set by the ECB. Therefore, if the ECB have to increase interest rates it will increase UK rates and therefore increase the cost for UK homeowners. If interest rates increase at the wrong time it could cause economic hardship for homeowners.
1. Mortgages are a high % of consumer’s disposable income and therefore are sensitive to changes in interest rates. UK House prices are a high ratio of average incomes. Many homeowners have had to take out mortgages 4-5 average incomes to get on the property ladder. This means mortgage payments are a high % of disposable income. If interest rates increase, it could make mortgages unaffordable. Continue reading →
A reader left a comment on a post saying the plural of Euro is Euro.
I was surprised to see this because according to the rules of English it should be Euros.
On researching the issue I found, that the European Commission did adopt Euro as the the plural of Euro.
However, rather bizarrely the Directorate-General for Translation (Eu body) advise using the plural form Euros for any publication intended for general publication.
It seems bizarre to have one official definition (which breaks the rules of English grammar) and then advise a different form for the general public.
In Ireland, the plural of Euro is supposed to be Euro. But, many have ignored the EU directive saying why should the EU dictate changes to the basic use of Language.
Personally I will continue to use the form Euros.
The English Style Guide of the European Commission Translation Service states:
12.12 … Guidelines on the use of the euro, issued via the Secretariat-General, state that the plurals of both ‘euro’ and ‘cent’ are to be written without ‘s’ in English. Do this when amending or referring to legal texts that themselves observe this rule. Elsewhere, and especially in documents intended for the general public, use the natural plural with ‘s’ for both terms.
Sometimes you can have too many commissions. They are complicating a simple issue.
Readers Question: Buying a new property in Montengro
215,000 Euros’s
paid 30% at exchange 1.47 to pound August 2007
20% due in 2-3 months. 43 ,000 euros
today exchange is bad news approx 1.23 to pound
further 30% due around Nov -Dec 2008
20% on completion around April 2009
1.What are your predictions for the pound euro exchange rate at the time points above. June 08 – April 09?
I would be reluctant to stipulate a figure for the Euro / Pound exchange rate, especially with so much resting on your decision. People do talk of an exchange rate of 1 Euro to £1. This is because:
Weakness in UK housing market and UK economy. This could lead to lower interest rates in the UK in the next 12 months. If the UK housing market really collapses as some people fear, the £ will only get weaker.
Chance of Euro becoming worlds’ reserve currency instead of dollar. If central banks made the switch to the Euro, it would continue to gain in strength for a long time.
