Britain, the euro, and the five tests.

• Author: Minford, Patrick
• Position: Monetary unions

In this article, I consider the alleged economic benefits and potential costs to Britain of joining the European Monetary Union and adopting the euro. While Her Majesty's Treasury (2003) organized and reported on the issues in the form of the well-known Five Tests set out by the Chancellor, I have found it helpful to my own thinking to organize them in the form of key arguments for and against Britain joining the euro. I have therefore set them out in that way here, on the assumption that others too could find this helpful.

Fortunately, economics has developed fairly robust means of testing arguments and evidence. There is a body of economic theory within which the logic of arguments can be evaluated. Furthermore, we have increasingly good access to data and econometric tools, so that evidence can be brought to bear. This means that, much as some participants in the debate would like the economics to be vague and impressionistic so that political preferences could easily be dressed up as economic arguments, modern economics does not easily oblige.

My aim is to set out in as clear a way as I can what the economic arguments are on both sides, and then to discuss what theory and evidence we can bring to bear on them so as to evaluate the gains and losses to the U.K. economy if Britain were to join the eurozone.

Economics is a quantitative subject; therefore what is true for Britain may not be true for other countries. We will see that there are both gains and losses. For Britain the calculation will depend on its particular characteristics. For other countries with other characteristics the calculation may well be different.

Alleged Benefits of Joining the Eurozone

The economic benefits put forward for joining the EMU consist of three main elements: (1) the reduction in transactions costs of changing currency; (2) the reduction of exchange risk leading to greater trade and foreign investment with the rest of Europe, and to a lower risk-premium embodied in the cost of raising capital; and (3) increased transparency in price comparison.

Transactions Costs

Joining the EMU would mean that currency exchange between pounds and euros would no longer occur; this would save resources (reflected in the margins of currency dealers in a competitive market). The European Commission (1990) did a study of the savings and found that on average across the EMU members there would be savings in dealers' margins of 0.4 percent of GDP. However, for countries with advanced banking systems, such as Britain, it found the saving to be much smaller, at around 0.1 percent of GDP. The reason was that the vast proportion of currency exchanges between pounds and euros take place via the banking system (as for example in interfirm trade payments or credit card payments). These transactions, whatever margins may be marked up on them, are costless in resources since in a computerized banking transaction conversion of a payment into another currency requires the computer merely to perform one extra operation, at essentially zero marginal cost. So the cost only arises when people change hand-to-hand currency, basically small tourist transactions.

For Britain, 0.1 percent of GDP is about 1 billion £ per year--a fairly small sum though of course it is a gain that in principle continues indefinitely, at a level depending on the share of such currency exchanges in GDP. It seems rather likely in fact that these exchanges will steadily diminish in importance as credit card and other banking payment mechanisms penetrate ever deeper into tourist practice. A reasonable practical assumption might be that it remains about constant in absolute terms at 1 billion £ in today's prices.

The transactions cost argument does not end there. In order to join the EMU there must be a large one-off transactions cost in the form of changing the pound into euros--including changing over the vending machines, the accounting systems, and the banks' high street machines. There has been a range of estimates of this, which were usefully reviewed recently by the House of Commons Trade and Industry Committee (House of Commons 2000), together with its own work. The Committee concluded that a reasonable central estimate of the changeover cost was 30 billion £.

To reach an overall assessment of the net transactions cost, one must either turn this last one-off cost into an annual charge or convert the ongoing gain into an equivalent present value. This is easily done. If we take the real rate of interest as around 4 percent, then the annualized charge on 30 billion £ is 1.2 billion £, slightly more than the 1 billion £ annual gain. Or equivalently the present value of 1 billion £ is 25 billion £ (1 billion £/0.04), rather less than the one-off cost. By playing with the real rate assumed, one can push the comparison either way; and in any case both sets of estimates must be regarded as of doubtful accuracy. In other words, the transactions cost argument for joining the eurozone turns out to be on balance of little weight.

Exchange Risk, Trade, Foreign Investment, and the Cost of Capital

The core argument for entering the EMU is the elimination of exchange risk against the euro. It is argued--for example, in The Case for the Euro (Britain in Europe 2000)--that this elimination is like the removal of a trade barrier and will promote much more trade with Europe, increase foreign investment in Britain, and reduce the cost of capital by merging the rather risky and limited sterling capital market into the bigger and less risky euro capital market.

Let us examine this argument in two stages. First, let us assume that exchange risk is an important influence on trade, foreign investment, and the cost of capital. Second, we will consider this assumption critically.

So, assuming exchange risk is a big factor, consider whether adopting the euro will actually reduce that risk and, if so, by how much. Here we immediately trip over the key point that joining the EMU is not to join a world currency but a regional one. Unfortunately for our exchange risk we trade very heavily with the dollar area. Let us not get tied up in the vexed question of the exact shares of our trade with Europe and the United States, and what sorts of trade should be counted (goods? goods and services? or all cross-border transactions including foreign investment and earnings on them?). The point is that if we regard exchange risk as a sort of tax on...