Is the Euro Doomed to Fail

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<ul><li><p>8/2/2019 Is the Euro Doomed to Fail</p><p> 1/8</p><p>Is The Euro Doomed To Fail? Discuss</p><p>One cannot begin to consider this question without explicitlydefining the term fail. For the purpose of this essay, it shall meanthat the costs of the introduction of the Euro exceed the benefits.</p><p>Therefore if the Euro fails, net macroeconomic performance of allEurozone countries is worse than it would have been without itsintroduction. The word doomed refers to the future, meaning thatthis essay will have to look at the likelihood of failure in the future.To analyse this, we may compare the economic performance ofsimilar countries with and without the Euro and certain ones beforeand after the introduction its introduction. The Eurozone or EMU(European Monetary Union) is to be defined as the collection of the16 countries whose official currency is the Euro (Austria, Belgium,Cyprus, Finland, France, Germany, Greece, Ireland, Italy,Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Sloveniaand Spain). Although euro coins and banknotes entered circulationon 1st January 2002, the currency entered the financial markets 3years prior to that date. However, 1st January 2001 shall be the datethat we consider as the introduction of the Euro as it would havealso allowed time for any financial changes to come in to effect.</p><p>It is important to outline at least one issue with a currency unionthat has become particularly pertinent within the EMU. For allcountries to share a currency, there must also exist a commoncentral bank (the European Central Bank (ECB)) and therefore</p><p>common monetary policy. This is a necessity as if two Eurozonecountries had different policy rates, investors could constantly profitfrom arbitrage opportunities (higher returns with no extra risk) andas 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 ofan exchange rate appreciation. To be clear, one common policy ratedoes not mean that all interest rates are the same as the spreadbetween the policy rate and bond yields will differ depending onfactors such as creditworthiness of the sovereign and futuremacroeconomic prospects. In any case, the problem with a common</p><p>policy rate is that it cannot be changed to counter cyclicalmovements in specific countries. This is a problem as Eurozonecountries may be in different stages of the trade cycle, or some maybe prone to more depressed fluctuations in economic activity thanothers, thus require less radical rate changes. The ability ofmonetary policy to control national inflation rates diminishedlargely. This issue exists within almost every economic tradingblock, ie within the UK, inflation differs between regions usuallyprices rise faster in the south than the north but it is far moresevere on an inter-, rather than intra-national scale. Furthermore, itis often the countries with smaller economies that lose out asFrance and Germany usually have more lobbying power to influencemonetary policy according to their own needs. In the future, this is</p></li><li><p>8/2/2019 Is the Euro Doomed to Fail</p><p> 2/8</p><p>likely to become more of an issue. As emerging markets economies(eg. Slovakia) grow, their trade cycles will become more relativelyinfluential in the EMU and as a consequence, their lobbying powermay increase. This may potentially lead to more conflict overmonetary policy as political tensions rise. The significance of this</p><p>point depends on how well the economies of the EMU move intandem if their trade cycles coincide, this point is of littleimportance.</p><p>However, the more likely case is that some countries experiencemore fluctuating GDP and inflation than others eg economiesbased on consumer good production may experience more stablegrowth than those focused on capital good manufacturing due tothe accelerator effect. This means that one common policy ratechange is not suitable for the whole region, and the rate may be forinstance, too high for certain economies to recover from deep</p><p>recessions. Furthermore, for a minority of countries currently withhigh inflation rates, price competitiveness of exports monetarypolicy is still reflationary. Then again, this could be beneficial in thelong term if firms are forced to increase innovation and efficiency tosurvive, increasing long-term productive potential.</p><p>The chart above shows how much real growth rates in 2009 inEurope differ between countries. It is not possible to implement apolicy rate change that increases Greeces growth rate whilstslowing Slovakias. Therefore the data supports the argument to anextent. However, by and large, the Eurozone countries growth ratesare similar in the range of 1% to 2%, meaning that the argumentis not so relevant. One must also recognise that it has another flaw.Monetary policy is not the only way to dampen fluctuations ineconomic activity. Member countries have largely independentcontrol over their fiscal policy. This can be more tailored toindividual economies, using changes in taxation and government</p><p>spending to control effective demand and affect the real economy.For example, if monetary policy is too loose, then tighter fiscal</p></li><li><p>8/2/2019 Is the Euro Doomed to Fail</p><p> 3/8</p><p>policy can be implemented to counter the effect. However, fiscalpolicy does have its limitations. The EMU enforces the Maastrichtfiscal criteria to avoid excessive budget deficits and manage debt tomaintain confidence in the Euro and stability mean that the reversecannot be implemented too liberally, leaving some lack of freedom</p><p>in policy-making. It is relevant to point-out how Greeces debtproblems originated from her not keeping to these regulations asstated by The Stability Pact designed specifically to avoid this styleof crisis.</p><p>One reason why the Euro is beneficial is that it reduces exchangerate risk with other non-EMU investors. Until the financial crisis,investors believed that the Euro was more-or-less stable and couldnot experience radical fluctuations, as an exogenous shock to oneeconomy is unlikely to affect expectations of the Eurozone as awhole, thus ensuring stability.Clearly this point depends on the type</p><p>of shock the financial crisis in fact affected every Eurozoneeconomy, so the Euro was no more stable than any other currency.Even so, the Euro has opened-up some developing economiesfinancial markets such that investors are more willing to lend toeconomies such as Malta and Slovakia as they are less concernedabout exchange rate risk (risk due to changes in the exchange ratepotentially diminishing profits). Beforehand, if an investor were tolend to a Slovakian country, he would have to consider how theSlovak koruna was going to change in value. Foreign exchangemarkets in this currency would have been extremely illiquid, making</p><p>it harder to find counterparty with which to trade and often meaningthat it is far more volatile. The Euro offers stability and liquidity toinvestors, which encourages FDI. In the case of Slovakia, along withlow wages and tax rates, the introduction of the Euro has helped FDIinflows to grow more than 600% from 2000, largely helpinginfrastructure and business development. Moreover, trade ingeneral with non-Eurozone nations should rise for similar reasons. Itis easier to buy and sell Euros than koruna, and also less risky,encouraging international trade, which brings with it technicalexpertise and access to foreign markets according to Stiglitz.</p><p>However, more recently, the theory has departed from reality.Below is a graph showing the exchange rate between the Euro andthe US dollar from Yahoo Finance:</p><p>Indeed, between 2006and 2008 the Euro wasrising an extraordinarilysteady rate, but in mid-2008 the financial crisishit European exportshard and demand for</p><p>the Euro fell sharplyagainst the dollar.</p><p>QuickTime and adecompressor</p><p>are needed to see this picture.</p></li><li><p>8/2/2019 Is the Euro Doomed to Fail</p><p> 4/8</p><p>Since then, the Euro has moved far more erratically andunpredictably, 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 furthercause of volatility. In addition, the volatility itself has induced a self-</p><p>perpetuating cycle, where lenders no longer demand the Euro asnot only are they afraid of default, but also of the situation that theEuro has fallen sharply at the time when the principal is paid-back,wiping out their profits, causing a further fall in demand andexchange rate. Although this depreciation may be beneficial forexports, this is only in the short term and is likely to increaseinflation in some countries due to higher import prices (cost-push)and rising AD due to higher exports (demand-pull). This risk isgreatest in more open economies, of which there is a large range inthe EMU, meaning that the common monetary policy argumentbecomes more pertinent. In extreme circumstances, if wealthyEuropean individuals and firms decide that they no longer want tohold Euros due to their falling value, but dollars instead, the effect ismagnified and ultimately many benefits gained from the Eurodisappear, whilst the monetary policy problem still exists. Eventhough the positive results of the European bank stress tests mayhave restored some confidence, they were highly criticized for beingtoo lenient and financial markets did not react much. Consumerconfidence figures still remain fair from their peak, strengtheningthe case for the failure of the Euro.</p><p>QuickTime and adecompressor</p><p>are needed to see this picture.</p><p>One of the aims of the Euro was to encourage trade betweenmember countries so that each can profit from the benefits ofinternational trade. The theory goes as follows: a currency union</p><p>eliminates some transaction costs between countries. When twofirms trade with different currencies, they must either both converttheir currency to a common one, such as the US Dollar, or usuallythe buying firm (firm A) will convert his currency to the selling firms(firm B)preference.This inducestwo problems:firstly, thefinancialinstitutions</p><p>which executethis foreign</p><p>QuickTime and adecompressor</p><p>are needed to see this picture.</p></li><li><p>8/2/2019 Is the Euro Doomed to Fail</p><p> 5/8</p><p>currency trade often charge commission or make a margin on thetrade, essentially meaning that it costs the firms more money totrade with different currencies. Furthermore, if for example firm A isbuying car parts from firm B as it is an car manufacturer, changes inthe exchange rate mean that firm B cannot accurately forecast its</p><p>future costs, potentially discouraging some trade due to uncertaintyabout whether or not it is cheaper to buy now or later. Nowadays,with developed financial markets, such firms are able to purchasefutures or options contracts essentially a hedge against such riskso that it can be certain of future costs. However, the seller of suchproducts charges a risk premium for taking on the risk himself,thus generating a cost for the firm. With the Euro, both transactionand financial costs are reduced or eliminated, shifting the supplycurve right in most international markets, raising trade and output.Below is a graph showing a ECB measurement for Eurozone tradeover the past 20 years.</p><p>The data shows how trade between Eurozone countries almosttrebled between the introduction of the Euro and mid-2008. Despitethe large decline in 2008-09 caused by the global recession, tradehas increased at an even faster rate than it was rising before thecrisis. This shows that the Euro has enormously aided trade betweenmember countries, allowing them to profit from Ricardos</p><p>comparative advantage theory each country can raise output byspecialising at producing what it is best at, and then trading thesurplus for foreign goods. On the other hand, the rate of growth oftrade is not much different with the Euro, as before 2001, the chartshows how it was rising rapidly, largely due to the fact that theexchange rate fluctuations between countries that adopted the eurowere already low before the formation of the EMU. Perhaps then, theEuro is not necessarily a causal factor for this rise.</p><p>QuickTime and adecompressor</p><p>are needed to see this picture.</p></li><li><p>8/2/2019 Is the Euro Doomed to Fail</p><p> 6/8</p><p>In comparison, the above graph shows the same indicator for theUK. The UK has clearly experienced more erratic trade patterns andnotably suffered a 33% decline in trade due to the global recession,whereas the EMU as a whole only experienced a 28% decrease. Inaddition, the recovery of trade in the EMU has been more rapid than</p><p>in the UK. Also, where trade fell for the UK between 2001 and 2004,the Eurozone remained stable. This may mean that a currency unionincreases resilience of trade to external shocks and allows forstronger recovery in trade from them. On the other hand, thedifferences may be due to other factors, such as UK domesticdemand falling or lagging competitiveness of exports. On balance, itis likely to be a combination of the two as all the currency unionreassures importers and gives them confidence over future costswhereas UK importing firms may prefer not to take on such riskduring hard times.</p><p>A further problem with the Euro is that countries lose the power toalter the exchange rate to alter their Balance of Payments. Often, ifin recession a country may choose to lower interest rates in order todevalue their currency so that exports become cheaper and so longas the Marshall-Lerner condition is satisfied, their current accountposition will improve. Along with this, export industries may growand employ more labour, thus dampening the real consequences onthe economy. Due to the ECB, this cannot be done and countriesmay suffer in the short-term from high unemployment, such asSpain (over 20% April 2010) whose tourism industry was particular...</p></li></ul>


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