What if the UK had Adopted the Euro?

Arguably, one of the things that sets us apart from the rest of the animal kingdom is our ability to pose “what if” questions —not only regarding our past, but more importantly when planning our future. The same holds for policy-makers: those charged with formulating economic policy make a sort of national sport out of it.

Posing what-ifs regarding past affairs usually involves formulating so-called counterfactual scenarios, i.e. scenarios that differ from what actually happened: the if-I-had-bought-Microsoft-shares-back-in-1980 sort of thing. Such exercises are a staple in economic policy-making and can be quite useful in plotting a future course of action—in order to avoid committing the same mistakes again, for instance. All the more convenient, then, to have models at your disposal to help you explore the possible outcomes.

This is where econometrics guru M. Hashem Pesaran, of the University of Cambridge, comes in. Together with his colleagues Stephane Dees, Filippo di Mauro, and L. Vanessa Smith, he earlier developed a model called Global Vector Autoregression, GVAR in short, which helps to analyse economies and forecast their future performance. Now, together with L. Vanessa Smith of the University of Cambridge and Ron P. Smith of Birkbeck College/University of London, he has applied this model to develop a conceptual framework for the analysis of counterfactual scenarios and published his findings in his latest CESifo Working Paper. He illustrates his approach by examining what would have happened to the UK and euro area (EA) economies if the UK had adopted the euro in 1999.

This is not just a rhetorical question. With some EA countries now muttering darkly about the advantages they lost by adopting the euro and the flimsy gains they made from it, it makes sense to explore this particular what-if. In addition, while there is a vast literature on various aspects of the euro, including a massive research project conducted by the UK Treasury involving many independent academics and published in 2003, none of it seems to address the question posed by these researchers.

The researchers’ baseline looks at the effect UK entry in the first quarter of 1999 at the then-prevailing exchange rate would have had on output and prices in the UK and the EA over the five-year period until the end of 2003. To model long-term commitment, they imposed the entry restrictions for 10 years. To refine their model, they examined the robustness of its results to such assumptions as how the UK joined, when it joined and to the behaviour of oil prices and US equity and interest rates.

The authors look at the effects on both the UK and the EA, since they are very interdependent. The EA is the UK’s largest trading partner, with 53.7% of its trade, compared to 18% for the US. Conversely, the UK is also the EA’s largest trading partner, accounting for 23.8% of its trade as compared with 22.7% for the US. Changes in UK economic performance would have feedback effects on the EA, a feature duly allowed for in the GVAR model.

A Bit of Background
During the last quarter of the twentieth century, a central concern in European economic policy was to reduce exchange rate volatility. In 1988, the European Council confirmed the ultimate objective of Economic and Monetary Union (EMU). Three steps led to it, including the establishment of an embryonic European Central Bank in 1994 and the adoption of the euro as a virtual currency in 1999. Eleven countries fixed their exchange rates to the euro and adopted common interest rates, followed by Greece in January 2001. One year later, euro notes and coins entered circulation.

The UK, during that period, was concerned with controlling inflation. Several approaches were tried and discarded, until the UK decided to join the European Exchange Rate Mechanism (ERM) in 1990. Two years later, the UK – together with Italy – were ejected from the ERM by a large speculative attack. Italy later returned to the ERM and eventually the euro while the UK began a period of inflation targeting.

The Labour government elected in 1997 needed to show that it would follow a prudent monetary policy. As the authors point out, there were two obvious routes: rejoining the ERM and subsequently the euro, or making the Bank of England independent. The UK opted for the latter.

So what would have happened if the UK had opted for the euro? If you like complex econometric functions collecting every single character in three alphabets and dealing with a host of esoteric-sounding variables, you can follow the entire analytical procedure in the working paper. Here we’ll just cut straight to the findings: entry to the euro in 1999 at the then prevailing exchange rate would probably have reduced UK GDP in the short term and raised it in the longer term, albeit by small amounts. UK entry would have probably caused EA GDP to be lower, with lower prices in the UK and higher ones in the EA. In other words, UK entry would have been bad for the EA, because of lower output and higher prices, though the effects are small.

The conclusion is quite robust to alternative scenarios, including different initial conditions and accounting for various global shocks during the period. Still, the authors are careful to point out that, until parameter and model uncertainty have been thoroughly analysed, these results are tentative. They also point to the importance of permanent appreciation or depreciation of the sterling-euro rate on entry, and of other channels such as national debt and budget deficits.

Nonetheless, the findings do appear to vindicate the euro-aloof stand adopted by the UK: Britons wouldn’t have gained enough to make it worth relinquishing their monetary independence. The surprising thing is that the EA would not have profited at all from bringing one of its wayward children into the fold.

The approach developed by Mr Pesaran and his team can be used to examine a range of other counterfactual scenarios, such as the possibility of China pegging her currency to the yen rather that to the US dollar, or the effects of a policy committed to holding interest rates unchanged and so on. Or to see what would have happened if you had bought those Microsoft shares back then after all.

M. Hashem Pesaran, L. Vanessa Smith & Ron P. Smith: What if the UK had Joined the Euro in 1999? An Empirical Evaluation Using a Global VAR, CESifo Working Paper No.1477

• Other CESifo Working Papers dealing with the European Monetary Union
• Other CESifo Working Papers by M. Hashem Pesaran
• CESifo Working Papers published in the past three months