The Euro was launched in 1999, replacing a wide range of currencies throughout continental Europe with a single currency of equal value in all nations. The main aim of the single currency was to assist in the movement of trade and labour, by making it easier for businesses and individuals to compare costs, prices and salaries across the entire EU. However, as will be shown below, the Euro has not always had the desired benefits, and has in fact led to some serious issues due to the lack of structural flexibility in many of the Eurozone countries.
The major benefit of the Euro is that it offered common stability across a large portion of the European Union, helping weaker currencies such as the Franc and Lira by coupling them to the stronger ones such as the DeutscheMark. As such, this prevented the previous swings in currency value which periodically affected several European currencies, and thus helped stabilise the value of the high volume of trade within the European single market.
Indeed, until the launch of the Euro, it was argued that the common market in the EU has delivered very few gains in productivity or efficiency, as trade in the market still had to take place with different currencies and the same exchange rate exposure risks. However, the Euro has made it easier to compare wages, prices and costs across the entire Eurozone and know that, if a supply chain is set up to profitably move goods from one part of the EU to another, exchange rate fluctuations will not act to undermine this profitability (Economist, 1998).
In addition, the creation of a European Central Bank to oversee monetary policy across the entire Eurozone, with a commitment to ensuring low inflation and consistent pricing throughout the zone, offers significant benefits. In particular, it offers significant benefits to nations which have poor track records in attempting to manage their internal inflation, as the connection to the other Eurozone economies will allow them to benefit from shared inflation pressures.
As such, this also allows Europe a significant gain in macroeconomic stability, which the continent has arguably never experienced before. In addition, the overall level of microeconomic benefits were argued to be vast, with the EU estimating that the Eurozone could save 0.5% of its total GDP each year thanks to lower hedging and transaction costs; an initial saving of around $40 billion (Prati and Schinasi, 1998).
Indeed, these hedging and transaction cost savings offer significant benefits to the capital market as well, with the Euro facilitating a single capital market across Europe, with substantially lower costs of capital. Indeed, the ability of companies to borrow from a central and sophisticated source of finance will be much simpler than attempting to tap small and underdeveloped domestic markets. This has a significant benefit for small businesses in some of the weaker economies in Europe, who would find it difficult to find suitable finance packages when the capital allocation process is weak. It will also open up the securities markets for investors, offering them a wider choice of investments and a significant reduction in costs (Askari and Chatterjee, 2005). As such, the combination of the removal of exchange rate uncertainty; low levels of inflation; easier trade terms; and more efficient markets give the potential of big benefits.
In addition, the previous policy driven currency shocks which have hit Europe in the past will have less of an impact under a single currency. Whilst the ECB’s monetary policy will have different impacts on the various Eurozone economies; they will at least tend to act in the same direction. As such, this will help avoid issues such as the monetary crisis in the 1990s, when the UK left the ERM and central banks across Europe reacted in different ways to defend their own currencies. As such, this concerted movement, combined with an increase in trade, should help business cycles to converge across Europe, as consumer strength in one area of the Eurozone is transmitted to all other areas through trade (Koozman and Azevedo, 2008). This will help keep economic growth steady and balanced throughout the entire zone, and ideally eliminate the need for sudden monetary policy shifts. (This is Timothy Ijoyemi work)
However, the introduction of the Euro also involves risks for the individual economies; who have given up the ability to change their domestic interest rates and to allow their currency to appreciate or depreciate against other Euro members. This will result in a significant loss of flexibility for these economies, which may prove critical if their economies fail to adjust in line with each other, as Smith (2008) has argued is now happening, with the ‘PIGS’ economies falling far behind their partners. As such, it is possible that the Eurozone will fail to function as an optimal currency area, and business cycles may diverge across countries if they are exposed to different external factors. For example, a recession in Latin America would potentially be more likely to affect Portugal and Spain, as major exporters to Latin America, than Italy and Greece.
Such an occurrence could cause a slowdown in the economies of Spain and Portugal, and they would be unable to lower interest rates in an attempt to stimulate their domestic economies. Whilst the common market in theory allows for the free flow of capital and labour to adjust for such issues, businesses may not wish to invest in the slower growing regions without the benefit of lower interest rates. Whilst incentive packages could be used to encourage this investment, this would effectively involve the faster growing countries subsidising their slower growing counterparts; something which they may be unwilling to do (Economist, 1998).
In addition, there is no guarantee that economies will converge, particularly if Germany continues to focus on manufacturing whilst France, for example, begins to specialise more in financial services. Tyson (2000) cites economic data from some of the world’s most developed countries to indicate that closer degrees of economic integration tends to produce more synchronised business cycles. However, the economies will still remain vulnerable to asymmetric economic shocks, particularly in the years immediately after integration. As such, one major drawback of the Euro is that it does not completely remove the chances of major asymmetric shocks, whilst stopping countries from using one of the major policy instruments to counter it: the ability to adjust domestic interest rates (Tyson, 2000).
Barrell and Weale (2003) argue that, not only does the common monetary policy have the potential to be too tight for stuttering economies, but it may also be too loose for rapidly growing economies. This is particularly important as the booming economies in Eastern Europe begin to join the Euro: some of these will have domestic inflation that cannot be controlled by the ECB’s central rate. Whilst this can be countered by national fiscal policies, such as raising taxes or reducing levels of government spending, this may be difficult to do considering that these countries will likely have had to control their spending in order to qualify to join the euro, and may thus be running and unsustainably large fiscal surplus (Barrell and Weale, 2003).
In addition, the fundamental structural changes required to achieve the common market are likely to prevent it from achieving the flexibility required to drive convergence. In particular, Hein and Truger (2005) argue that labour and wages in the European Union are extremely inflexible, and the cultural, language and geographic barriers that remain in Europe make it unlikely that many Europeans will take advantage of the freedom of movement.
As such, any region that experiences a decline will likely end up having to wait for the business cycle to adjust in order to recover. Indeed, regions such as southern Italy and eastern Germany have not fully recovered from their economic slumps in spite of the arrival of the Euro, and now have lost the ability to devalue against their potential export markets. A final drawback for the Euro is that the natural barriers to flexibility discussed above are further exacerbated by a significant level of rigidity and job protection in the EU labour laws (Grenier and Tran, 1997). Whilst this is not a drawback to the Euro itself, it further increases the likelihood of some regional and national economies overheating whilst others go into recession.
In conclusion, whilst the Euro has many potential benefits, the lack of flexibility and coherent structural reforms in the Eurozone have led to many of these benefits not being realised, and has served to exacerbate the drawbacks in some areas. In particular, the Euro has failed to drive structural reform in many nations, and the loss of economic flexibility and rigid labour laws make it difficult for the Eurozone economies to attract the labour and capital necessary to maintain economic stability. Explain what effects might the present rise in the value of the Euro relative to other currencies such as Sterling and the US Dollar have on Eurozone members and their non-Euro trading partners
A variation in the exchange rate of a country is most strongly connected to the strength of its imports and exports. For example, if one Euro goes from being worth one dollar to being worth two dollars, then 100 Euro worth of exports from a Eurozone country will now cost $200 in the US, instead of $100. This will obviously make them more expensive, and will reduce demand for them in the United States and other countries where the dollar is the major currency. However, there are also significant other impacts on market demand, and the fiscal balance issues discussed above can be exacerbated by a currency with a strong value, which can have different effects on the different national economies. These effects will be discussed in this piece.