The United Kingdom and the stability of the Euro area: From Maastricht to Brexit

• Date: 01 July 2020
• DOI: http://doi.org/10.1111/twec.12919
• Published date: 01 July 2020
• Author: Corrado Macchiarelli,Nauro F Campos

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wileyonlinelibrary.com/journal/twec World Econ. 2020;43:1792–1808.

Received: 20 March 2019

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Revised: 3 December 2019

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Accepted: 12 January 2020

DOI: 10.1111/twec.12919

ORIGINAL ARTICLE

The United Kingdom and the stability of the Euro

area: From Maastricht to Brexit

Nauro FCampos1

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CorradoMacchiarelli2

1ETH Zurich, University College London, London, UK

2London School of Economics, Brunel University London, London, UK

KEYWORDS

Brexit, business cycle, EU, UK

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INTRODUCTION

The year of 2019 was to mark the 20th anniversary of the European single currency (the euro) and the

expected exit of the United Kingdom, known as Brexit, from the European Union. It is then appropri-

ate to ask what will be the impact of Brexit on the stability of the euro area? Does Brexit undermine

the euro because it undermines the EU as a political and economic project, or will it allow the rest

of the EU to implement institutional changes that will help the euro work better? These are difficult

and pressing questions. The contribution of this paper is to provide some of the key elements for an

informed debate.

Regarding the stability of the euro area, a measure of how widely recognised are the current short-

comings of the Economic Monetary Union (EMU) is the Brussels’ plan for a Genuine EMU (Begg,

2014).1 Agreement on the need for a solution coexists with an apparently stark disagreement on the

causes. One view is that "design flaws" (De Grauwe, 2006;De la Dehesa, 2012) deepened imbalances,

while another is that "policy mistakes" (Sandbu, 2015) hindered convergence. One of the many pro-

posed solutions is a flexible euro (Stiglitz, 2016): a two-tier model of a Northern and a Southern euro

where the latter is said to be "softer." One way to explain such proposals is that the Southern euro

would not be part of the "core" or that it would be "less core." All these views, however, rely upon

"asymmetries": the less asymmetric, the more synchronised, the more stable will the euro area be.

Regarding Brexit, in June 2016, 52% of British voters decided that being the first country ever to

leave the EU was a price worth paying despite extensive advice from economists that Brexit would

make the UK permanently poorer (Campos, 2019). Moreover, Brexit is one among a constellation of

crises inflicting upon the EU (populism, refugees, debt, unemployment, etc.). Although one among

1 Sapir and Wolff (2016), Belke et al (2017b) and Macchiarelli (2017) discuss how progress towards the GEMU may affect

the UK.

This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and reproduction

in any medium, provided the original work is properly cited.

© 2020 The Authors. The World Economy published by John Wiley & Sons Ltd

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CAMPOS And MACCHIARELLI

many, Brexit differs in that it can alone ignite other crises. Brexit raises existential questions about the

integration project. It asks questions about the value of membership, the dynamics and distribution of

its benefits and costs, and the type of integration that can sustain the net benefits seen since the 1950s.

One of the few benefits of the Brexit debate is that it has fostered a flurry of new research addressing

questions that have not been sufficiently investigated previously. One of these questions regards cohesion

among euro area members, where the governance structure of the relationship between the countries that

use the euro as their currency (i.e. the euro-ins) and those that do not (the euro-outs) is an important

issue. The latter group includes both the countries that have negotiated the right to opt-out from partici-

pation under the Maastricht Treaty of 1992 (the euro-outs, i.e. the UK and Denmark) and those who are

on the path to eventual adoption of the single currency (the pre-ins, i.e. Central Eastern EU).

The paper is organised as follows. Section 2 provides a conceptual framework. It discusses the

theory of optimal currency areas, its recent developments and the centrality of the concept of syn-

chronicity. Section 3 analyses the extent to which economic activity in the UK is synchronised with

economic activity in the euro area and how this has changed over time—especially after the intro-

duction of the single currency. Consistent with the existing literature, we find synchronisation has

increased after the introduction of the euro. Section 4 introduces new empirical measures of economic

symmetry among European economies. Stability depends on the degree of integration among member

countries or, more specifically, on the relative distance between core and periphery countries. Using

these new measures, we show that the gap between core and periphery pre-EMU has diminished after

the introduction of the euro and that the UK contribution was key in the sense that it moved from the

periphery before 1990 to the core. On the other hand, the UK is also shown to be the one country in

which this measure post-euro has varied the most (i.e. has been the least stable). Section 5 discusses

policy implications to help increase the stability of the euro area. Section 6 concludes.

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INTEGRATION, SYMMETRY AND STABILITY

Sharing a currency deepens integration. The main research question driving the optimal currency areas

(OCA) scholarship regards the costs and benefits of sharing a currency (Alesina & Barro, 2002). The

main cost is the loss of monetary policy autonomy. Benefits are mostly in terms of reduction of trans-

action costs and exchange rate uncertainty, and increasing price transparency, trade and competition.

Glick and Rose (2016) summarise the econometric evidence on the trade effects of currency unions.

One insightful way of framing the OCA issue is proposed by De Grauwe and Mongelli (2005).

They study the interactions between symmetry, flexibility and integration. The more changes in the

levels of economic activity across countries happen in unison; that is, the more synchronised are their

business cycles, the more integrated will countries be. Particularly, they show there exists a minimum

combination of, for example, flexibility and integration that countries must observe for a monetary

union to generate positive net benefits. De Grauwe and Mongelli (2005) place the Eurozone (EU)

within (to the outside) of the OCA line, suggesting those countries are (not yet) sufficiently integrated

to generate efficiency gains that can compensate for the macroeconomic costs of the union. They also

note how the degree of economic integration and symmetry may change over time.

Before the EMU, there was an intense debate about the extent to which a monetary union affects

symmetry (Krugman, 1993). Focusing on the symmetry-openness dimension, one can see that in-

creased integration may raise business cycle correlation. De Grauwe and Mongelli (2005) argue the

EU would move in this way: they predict specialisation will bring about less symmetry.

There are at least two recent developments in OCA theory that should be noted. The original OCA

formulation stressed labour mobility, product diversification and trade openness as key adjustment