Christopher Johnson: A euro vision of future growth and prosperity

It has become the conventional wisdom, even among supporters, that the main advantages of British entry into the euro are political and that the economic arguments are finely balanced, impossible to prove and can point either way. However, recent research suggests that the economic advantages could, on the contrary, be very large, even if they take some time to come through.

There are two stages to the argument. First, being part of a single currency area boosts trade with the other members. Second, having a higher proportion of external trade raises gross domestic product per head, and thus living standards.

The evidence comes in "An Estimate of the Effects of Common Currencies on Trade and Income", a paper by two American professors, Jeffrey Frankel and Andrew Rose. They start by explaining international trade using the "gravity" model: it goes down with distance and up with size of economy. They then find that a single currency increases trade with the other members more than threefold, even after allowing for things that go with it, such as a common language and a shared colonial past.

Greater openness – doing more external trade – may be caused by trade liberalisation or by a single currency. The unprecedented world economic growth of the last half century was clearly due to some extent to the freeing of trade barriers, for example the creation of the European Common Market. Single currencies could give it a new lease of life.

Frankel and Rose measure the UK's external trade, meaning exports plus imports, at 58 per cent of GDP, of which nearly 31 percentage points are to the euro area and just over 27 to the rest of the world. They assume that the 31 will be tripled to 92 per cent of GDP if the UK joins the euro, while the 27 remains unchanged, with no diversion of trade – an important plus point. So total external trade rises to 119 per cent of GDP, an increase of 61 percentage points.

This increase in the external trade proportion would bring about a rise of one-third as much in GDP, in other words 20 per cent. This could not happen overnight. All the other measures needed to make the single currency effective might take up to 20 years. Even so, the UK's growth rate could rise by 0.9 per cent a year compound for 20 years, from the Treasury's central assumption of 2.5 to 3.4 per cent a year. This would make an enormous difference to living standards, to tax revenue and to public services.

The UK economy already does quite well out of being in a European common market. The half of our trade we do with the euro countries is a good launching pad to get the benefits of the euro, but only if we take off from it. Whether or not our trade with them is now enough to make the UK plus the euro countries an "optimum currency area", joining the euro area will increase it enough to make it so.

A single currency increases trade and investment in a way that fixed exchange rates do not, because separate currencies, even if fixed, carry transaction costs and, anyway, they do not stay fixed. The euro will work by offsetting the bias towards home goods in trade and by encouraging foreign direct investment. More foreign trade also means greater competition, which favours more efficient firms over their less efficient rivals. It cannot be good news for all firms – which is why some of them seek protection – but it must be good news for all consumers, leading to better products at lower prices. More foreign investment, on past showing in the UK, brings higher productivity and higher pay, and therefore a faster growth rate and better living standards.

The Government has given priority to raising British economic performance, particularly our low productivity record. If it does not soon join the euro, it will have one hand tied behind its back. It will be far better able to achieve its other economic objectives as part of a single currency area. It is inconsistent for us to tell the rest of Europe how to improve its economic policies if we fail to take the biggest step towards improving our own.

Christopher Johnson is UK adviser to the Association for the Monetary Union of Europe. The paper referred to can be obtained from arose@haas.berkeley.edu