Is The Euro Doomed To Fail?

Discuss
One cannot begin to consider this question without explicitly defining the term fail. For the purpose of this essay, it shall mean that the costs of the introduction of the Euro exceed the benefits. Therefore if the Euro fails, net macroeconomic performance of all Eurozone countries is worse than it would have been without its introduction. The word doomed refers to the future, meaning that this essay will have to look at the likelihood of failure in the future. To analyse this, we may compare the economic performance of similar countries with and without the Euro and certain ones before and after the introduction its introduction. The Eurozone or EMU (European Monetary Union) is to be defined as the collection of the 16 countries whose official currency is the Euro (Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia and Spain). Although euro coins and banknotes entered circulation on 1st January 2002, the currency entered the financial markets 3 years prior to that date. However, 1st January 2001 shall be the date that we consider as the introduction of the Euro as it would have also allowed time for any financial changes to come in to effect. It is important to outline at least one issue with a currency union that has become particularly pertinent within the EMU. For all countries to share a currency, there must also exist a common central bank (the European Central Bank (ECB)) and therefore common monetary policy. This is a necessity as if two Eurozone countries had different policy rates, investors could constantly profit from arbitrage opportunities (higher returns with no extra risk) and as there is no exchange rate mechanism to correct for this, countries could rates interest rates to benefit from more lending, and their export markets not have to suffer the usual side-effect of an exchange rate appreciation. To be clear, one common policy rate does not mean that all interest rates are the same as the spread between the policy rate and bond yields will differ depending on factors such as creditworthiness of the sovereign and future macroeconomic prospects. In any case, the problem with a common policy rate is that it cannot be changed to counter cyclical movements in specific countries. This is a problem as Eurozone countries may be in different stages of the trade cycle, or some may be prone to more depressed fluctuations in economic activity than others, thus require less radical rate changes. The ability of monetary policy to control national inflation rates diminished largely. This issue exists within almost every economic trading block, ie within the UK, inflation differs between regions usually prices rise faster in the south than the north but it is far more severe on an inter-, rather than intra-national scale. Furthermore, it is often the countries with smaller economies that lose out as France and Germany usually have more lobbying power to influence monetary policy according to their own needs. In the future, this is

likely to become more of an issue. As emerging markets economies (eg. Slovakia) grow, their trade cycles will become more relatively influential in the EMU and as a consequence, their lobbying power may increase. This may potentially lead to more conflict over monetary policy as political tensions rise. The significance of this point depends on how well the economies of the EMU move in tandem if their trade cycles coincide, this point is of little importance. However, the more likely case is that some countries experience more fluctuating GDP and inflation than others eg economies based on consumer good production may experience more stable growth than those focused on capital good manufacturing due to the accelerator effect. This means that one common policy rate change is not suitable for the whole region, and the rate may be for instance, too high for certain economies to recover from deep recessions. Furthermore, for a minority of countries currently with high inflation rates, price competitiveness of exports monetary policy is still reflationary. Then again, this could be beneficial in the long term if firms are forced to increase innovation and efficiency to survive, increasing long-term productive potential.

The chart above shows how much real growth rates in 2009 in Europe differ between countries. It is not possible to implement a policy rate change that increases Greeces growth rate whilst slowing Slovakias. Therefore the data supports the argument to an extent. However, by and large, the Eurozone countries growth rates are similar in the range of 1% to 2%, meaning that the argument is not so relevant. One must also recognise that it has another flaw. Monetary policy is not the only way to dampen fluctuations in economic activity. Member countries have largely independent control over their fiscal policy. This can be more tailored to individual economies, using changes in taxation and government spending to control effective demand and affect the real economy. For example, if monetary policy is too loose, then tighter fiscal

policy can be implemented to counter the effect. However, fiscal policy does have its limitations. The EMU enforces the Maastricht fiscal criteria to avoid excessive budget deficits and manage debt to maintain confidence in the Euro and stability mean that the reverse cannot be implemented too liberally, leaving some lack of freedom in policy-making. It is relevant to point-out how Greeces debt problems originated from her not keeping to these regulations as stated by The Stability Pact designed specifically to avoid this style of crisis. One reason why the Euro is beneficial is that it reduces exchange rate risk with other non-EMU investors. Until the financial crisis, investors believed that the Euro was more-or-less stable and could not experience radical fluctuations, as an exogenous shock to one economy is unlikely to affect expectations of the Eurozone as a whole, thus ensuring stability. Clearly this point depends on the type of shock the financial crisis in fact affected every Eurozone economy, so the Euro was no more stable than any other currency. Even so, the Euro has opened-up some developing economies financial markets such that investors are more willing to lend to economies such as Malta and Slovakia as they are less concerned about exchange rate risk (risk due to changes in the exchange rate potentially diminishing profits). Beforehand, if an investor were to lend to a Slovakian country, he would have to consider how the Slovak koruna was going to change in value. Foreign exchange markets in this currency would have been extremely illiquid, making it harder to find counterparty with which to trade and often meaning that it is far more volatile. The Euro offers stability and liquidity to investors, which encourages FDI. In the case of Slovakia, along with low wages and tax rates, the introduction of the Euro has helped FDI inflows to grow more than 600% from 2000, largely helping infrastructure and business development. Moreover, trade in general with non-Eurozone nations should rise for similar reasons. It is easier to buy and sell Euros than koruna, and also less risky, encouraging international trade, which brings with it technical expertise and access to foreign markets according to Stiglitz. However, more recently, the theory has departed from reality. Below is a graph showing the exchange rate between the Euro and the US dollar from Yahoo Finance: Indeed, between 2006 and 2008 the Euro was rising an extraordinarily steady rate, but in mid2008 the financial crisis hit European exports hard and demand for the Euro fell sharply against the dollar.

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Since then, the Euro has moved far more erratically and unpredictably, effectively rendering the earlier point insignificant. The lack of confidence in creditworthiness European sovereigns, particularly in the wake of the Greece debt crisis has been a further cause of volatility. In addition, the volatility itself has induced a selfperpetuating cycle, where lenders no longer demand the Euro as not only are they afraid of default, but also of the situation that the Euro has fallen sharply at the time when the principal is paid-back, wiping out their profits, causing a further fall in demand and exchange rate. Although this depreciation may be beneficial for exports, this is only in the short term and is likely to increase inflation in some countries due to higher import prices (cost-push) and rising AD due to higher exports (demand-pull). This risk is greatest in more open economies, of which there is a large range in the EMU, meaning that the common monetary policy argument becomes more pertinent. In extreme circumstances, if wealthy European individuals and firms decide that they no longer want to hold Euros due to their falling value, but dollars instead, the effect is magnified and ultimately many benefits gained from the Euro disappear, whilst the monetary policy problem still exists. Even though the positive results of the European bank stress tests may have restored some confidence, they were highly criticized for being too lenient and financial markets did not react much. Consumer confidence figures still remain fair from their peak, strengthening the case for the failure of the Euro.

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One of the aims of the Euro was to encourage trade between member countries so that each can profit from the benefits of international trade. The theory goes as follows: a currency union eliminates some transaction costs between countries. When two firms trade with different currencies, they must either both convert their currency to a common one, such as the US Dollar, or usually the buying firm (firm A) will convert his currency to the selling firms (firm B) preference. This induces two problems: firstly, the financial institutions which execute this foreign
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currency trade often charge commission or make a margin on the trade, essentially meaning that it costs the firms more money to trade with different currencies. Furthermore, if for example firm A is buying car parts from firm B as it is an car manufacturer, changes in the exchange rate mean that firm B cannot accurately forecast its future costs, potentially discouraging some trade due to uncertainty about whether or not it is cheaper to buy now or later. Nowadays, with developed financial markets, such firms are able to purchase futures or options contracts essentially a hedge against such risk so that it can be certain of future costs. However, the seller of such products charges a risk premium for taking on the risk himself, thus generating a cost for the firm. With the Euro, both transaction and financial costs are reduced or eliminated, shifting the supply curve right in most international markets, raising trade and output. Below is a graph showing a ECB measurement for Eurozone trade over the past 20 years.

The data shows how trade between Eurozone countries almost trebled between the introduction of the Euro and mid-2008. Despite the large decline in 2008-09 caused by the global recession, trade has increased at an even faster rate than it was rising before the crisis. This shows that the Euro has enormously aided trade between member countries, allowing them to profit from Ricardos comparative advantage theory each country can raise output by specialising at producing what it is best at, and then trading the surplus for foreign goods. On the other hand, the rate of growth of trade is not much different with the Euro, as before 2001, the chart shows how it was rising rapidly, largely due to the fact that the exchange rate fluctuations between countries that adopted the euro were already low before the formation of the EMU. Perhaps then, the Euro is not necessarily a causal factor for this rise.

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In comparison, the above graph shows the same indicator for the UK. The UK has clearly experienced more erratic trade patterns and notably suffered a 33% decline in trade due to the global recession, whereas the EMU as a whole only experienced a 28% decrease. In addition, the recovery of trade in the EMU has been more rapid than in the UK. Also, where trade fell for the UK between 2001 and 2004, the Eurozone remained stable. This may mean that a currency union increases resilience of trade to external shocks and allows for stronger recovery in trade from them. On the other hand, the differences may be due to other factors, such as UK domestic demand falling or lagging competitiveness of exports. On balance, it is likely to be a combination of the two as all the currency union reassures importers and gives them confidence over future costs whereas UK importing firms may prefer not to take on such risk during hard times. A further problem with the Euro is that countries lose the power to alter the exchange rate to alter their Balance of Payments. Often, if in recession a country may choose to lower interest rates in order to devalue their currency so that exports become cheaper and so long as the Marshall-Lerner condition is satisfied, their current account position will improve. Along with this, export industries may grow and employ more labour, thus dampening the real consequences on the economy. Due to the ECB, this cannot be done and countries may suffer in the short-term from high unemployment, such as Spain (over 20% April 2010) whose tourism industry was particularly damaged by the strength of the Euro. Not only does the Euro prevent the use of exchange rate policy, but it also impedes the natural self-equilibrating nature of a floating exchange rate. Disregarding speculation and FDI, demand for a currency is essentially demand for the countries exports and supply essentially its demand for imports. By the free market mechanism, these two forces should set an exchange rate that makes imports and exports equal. Admittedly, various other factors such as speculation (which is yet more offsetting in the case of the Euro as one large, more stable currency attracts more speculative action than many, less significant and more volatile ones) and current transfers distort these forces in the real world, but the logic still holds to an extent. However, with the Euro, the value is determined by exports and imports of the whole region, rather than that of certain countries, so although this mechanism may function for the whole EMU, particular countries may suffer excessive surpluses or deficits. This is because if demand for imports in one country rises, this will have little effect on the Euro as a whole, thus the currency will not depreciate and exports would not fall. Perhaps this partially explains Spains current account deficit of EUR57.2bn (~10% GDP), although for the EMU as a whole, the deficit is merely EUR55.8bn, only 2.47% GDP in 2009. However, this is not necessarily a disadvantage as current account deficit management is not such a high priority. It could be argued that if an EMU country faces a shock, AD and the price level may

fall, making exports more competitive. As this is unlikely to cause the value of the Euro to rise due to its small relative size, the country benefits from low prices and a low exchange rate, meaning that exporting industries become more competitive and boost growth. The significance of this depends on the nature of the shock; the larger and more widespread through other countries the shock is, the more likely that greater export demand will cause the Euro to appreciate and these benefits not to be realised. Despite the previous argument, Mundells work on Optimal Currency Areas (OCAs) advocates that countries with similar economic and industrial structures are likely to work better in a currency union. They are likely to face common shocks, which can be dealt with by a common monetary policy, argues Begg. He also argues that countries which trade a lot with each other and those with flexible labour markets who can easily accomplish changes in the real exchange rate at competitiveness by changes in the price level will benefit most from a common currency. Bayoumis and Eichengreens studies show that Europe is quite, but not very integrated and there is an inner-core of countries (France, Germany and Italy) more integrated than the rest. In light of this evidence, perhaps the Euro is used by too many countries for it to benefit enough, as universal monetary policy would be more appropriate with a smaller group. Furthermore, European labour markets are notoriously sluggish and inflexible due to hiring and firing regulations. This means that wages often take time to changes in market forces (ie fall in demand for labour not immediately causing a fall in the wage rate, and therefore real exchange rate with other countries) compromises price competitiveness of domestic goods and exports. This point depends on the flexibility of labour markets in trading partner countries if they are also inflexible and wages do not adjust, inflation abroad may also remain high, so relatively there will be little change. However, in reality the USA is a main trading partner of most European countries and has far more flexible labour QuickTime and a decompressor markets, making this argument are needed to see this picture. rather compelling towards the Euro being doomed to fail. Concerning growth, the Euro has maintained stability in GDP in the EMU since its formation, as can be seen on the graph to the right. However, there is little difference in the GDP growth rate of the EMU countries since 2001, potentially undermining the effect of the Euro. Also, non-EMU countries have benefitted from similar, if not faster growth rates, such as Denmark, shown below.

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Again then, it is hard to isolate the effect of the Euro, but even so it is evident that it has had little or no negative effect on GDP growth. On balance, the Euro is unlikely to fail in the near future, but not succeed by any extraordinary measure either. It has proved resilient to the global recession and debt problems in Greece. Confidence in the EMU is on the rise and the rebound in trade will permit countries to benefit from increased market integration and reduced risk involved in internal trades. Nevertheless, the currency union would be a greater success had it been confined to a more similar cluster of economies as this would minimise problems generated from a universal monetary policy.