European Interest Rates example essay topic

Economic consequences of a Single European Currency A large part of the attraction to those businesses which have declared themselves in favour of joining the single currency lies in the notion that Euroland will be a zone of economic stability, within which effective business planning can take place and growth be enhanced. But will Euroland in fact exhibit these characteristics Will it be a zone of stability Will it be a zone of growth Will it be a zone of high employment The answer to all three questions could well be a 'no'. We will certainly need to experience more than one economic cycle before being able to answer with any certainty. To start with the question of stability. There will be one European Central Bank. This ECB will set one interest rate across a vast area of Europe, from Lisbon to Berlin.

What we can say with certainty is that, whatever rate the Bank sets, for many countries it will be wrong for most of the time. For some countries it will be too high, for others too low. It is perfectly clear what is likely to happen in both sets of circumstances. The UK experienced the effects of an interest rate which was too high the last time we participated in the European Exchange Rate Mechanism. Having to adopt German interest rates in this country between 1989 and 1992 produced an economic slump which showed no sign of ending until the pound finally broke free of the ERM and was devalued by 20%. Were the UK to enter the single currency zone when European interest rates were a lot lower than in the UK, the effect would be sharply accelerating inflation followed by several years of recession since British goods would have become priced out of European markets.

The only weapon a British government would retain against inflation would be savage tax increases. So those countries where interest rates are too high will be depressed by the unified European interest rate; whereas other where rates are too low will be destabilised in the opposite direction. Moreover, as the ECB moves the European interest rate up and down, the impact of the changes will vary from one country to another. In particular, the UK economy is far more responsive to interest rate changes than continental European countries. In 1997, the Pennant Rea committee, made up of a number of distinguished economists, calculated that because of the high level of variable-rate mortgage debt in Britain, UK GDP was four times as sensitive to changes in interest rates as the average for EU countries.

The Oxford economist, Walter Elt is, has calculated that if this is correct it means in turn that 2/5 of the entire response to changes in European interest rates would be borne by the UK. Thus, whilst instability would be increased around Europe, with some countries inflating whilst others fell into recession, the UK economy would be particularly destabilised by the new European arrangements. On the prospects for growth, the private sector across continental Europe, in contrast to the UK, has created no jobs in aggregate since 1970. It has done a bit better just recently, as a result of the fall in the D-mark and its associated currencies against the dollar and the pound. But this exchange-rate boost could prove short-lived. The situation in Europe could be much worse than this; for the Treaty rules of Economic and Monetary Union constitute a deflationary trap.

Most countries only just qualified for the single currency zone, by squeezing their borrowing just below the allowable 3% of GDP, helped by the temporary upturn. Whilst therefore there is scope to tighten fiscal policy by raising taxes or cutting public spending, there is no scope to relax it. Were a worldwide recession to gather pace at any time there would be no scope for those countries in Euroland, on the fiscal side, to counter the effects of the crisis. Indeed, under the rules, if recession takes hold and causes fiscal deficits, member governments would be obliged to cut back, by increasing taxes and cutting spending, in order to stay within the rules; action which would make the recession worse.

The rules governing this monetary union are in many ways out of date. They were constructed to prevent inflation accelerating. The problem may not be inflation but deflation, not boom but slump. The design cannot deal with this challenge. Now the French and German governments are talking about changing the rules. This political clamour demonstrates the extent to which inflexibility is built into any Treaty based Economic Monetary Union.

A single nation, by contrast, has no need for a Treaty and an inflexible system: it is free to respond flexibly to market situations, and economic circumstances, as they arise. Could the single currency area be a zone of high employment The record of the last 20 years proves that in the absence of strong cyclical growth, the conditions for high employment within Euroland simply do not exist. Economists describe the series of characteristics necessary to enable high employment levels to be maintained within a single currency area as including: flexible labour markets (ie flexible wages so that people can price themselves into jobs), labour mobility (so that the unemployed can move to where the jobs are) and a mechanism for transferring resources on an adequate scale from rich to poor regions of the currency zone. These conditions do not apply in the eleven countries that are part of the single currency area. And this is against the background that unemployment in Germany, France and Spain is already far higher than in the UK. So: the single currency area cannot be assumed to be a zone of stability; a zone of growth; nor a zone of high employment.

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