Readers Question on the Euro – How would Euro be affected if the UK had been a member?
Before the credit crisis and economic recession, I felt the Euro would be damaging to the UK economy.
To summarise this was because:
- Lack of Independent monetary policy, e.g. interest rates set by the ECB may not be suitable for UK economy.
- Inability to devalue exchange rate to regain competitiveness.
- Difficulty of fiscal union and geographical immobilities in an area as diverse as the EU.
To a large extent these concerns have materialised. Perhaps more than expected.
In 2008, the UK economy was much harder hit. The UK cut interest rates quicker than the ECB. The ECB also increased interest rates in 2011 when the UK economy was still weak. More importantly was the fact the UK could puruse quantitative easing which helped minimise recession.
These problems of the Euro proved to be very true. But, there was another problem with the Euro not many people predicted.
Being in the Euro leads to higher interest rates on government debt.
Many people felt being in the Euro would actually lead to lower interest rates. This is because Euro members could benefit from the fiscal strength of other countries. For a while this was true. A country like Greece with long term structural debt had similar interest rates to Germany because markets felt the Euro would definitely guarantee all Euro debt.
However, in a crisis situation markets learned two things
- There are great political difficulties to fiscal union. (e.g. German tax payers unwilling to buy Greek bonds when Greece has wasteful spending)
- Countries in Euro are more subject to liquidity shortages. With your own currency and monetary authorities, a temporary shortage of buyers can be solved by Central Bank just buying government debt to get through that liquidity shortage. But, in the Euro, this doesn’t happen. There is no Central Bank to jump straight in. You have to go to the ECB and ECB come back and say, well we might if you cut government spending by 15%.
Thus countries in the Euro, have greater pressure to reduce budget deficits because of market fears over liquidity shortages.
Therefore, they are pressured into fiscal austerity – cutting spending and increasing taxes. Yet, they have to do this without any other policy to compensate for the fall in aggregate demand. Therefore, there is a strong deflationary bias within the Euro. Countries are forced into this unenviable situation of trying to reduce budget deficits which cause lower growth (and lead to lower tax receipts.
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