The Single European Currency

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CONTINUE READING
The Single European Currency
A2 Economics

   The Single
   European
   Currency

Key Issues

• The essentials of Euro Area
  membership
• Convergence criteria
• Optimal currency area theory
• Recent macro performance of
  the Euro Area
• Single currency membership
  and external shocks
• The crisis for some Euro Area
  members

                                                 1
The Single European Currency
Basic history of the Euro Project

• 1991: Maastricht Treaty – pathway for Euro
• 1999: Euro starts life as a currencyy
• 1999-2001: Original members of system lock their
  currencies for two years
• 2002: Notes and coins come into circulation
• 2007: Slovenia becomes first of the new member
  states to enter the currency union
• 2008-09: Three new nations – Slovakia, Cyprus
  and Malta – the Euro Area extends to 16 nations
• 2009-10: Major stresses in the Euro as a fiscal
  crisis engulfs a number of member nations

The Euro Zone in 2006 – 12 Baffling Pigs

   Belgium
   Austria
   France
   Finland
   Luxembourg
   Italy
   Netherlands
   Germany

   Portugal
   Ireland
   Greece
   Spain

                                                     2
The Single European Currency
The Euro Zone in 2010 – 16 Members

   Belgium
   Austria                                             Slovenia
   France                                              Slovakia
   Finland                                              Cyprus
   Luxembourg                                             Malta
   Italy
   Netherlands
   Germany

   Portugal
   Ireland
   Greece
   Spain

  UK, Denmark and Sweden
  are all outside of the Euro

                                       Euro Essentials

• Monetary union is a deepening of economic integration
  between participating countries
• A single currency requires a common interest rate for
  the Euro Zone – i.e. a common monetary policy
• Countries have locked their currencies together forever
  and adopted one currency as a medium of exchange
• Euro as a currency floats against US dollar and sterling
    e be nations
• Member     at o s a
                    are
                      eaalso
                          so required
                              equ ed ((in p
                                          principle)
                                              c p e) to keep
                                                         eep
  control of government borrowing i.e. They are not
  allowed to run large budget deficits > 3% of their GDP
  (in normal times)

                                                                  3
The Single European Currency
Britain & the Euro – The Current Position

  • Britain is outside of the Euro Zone
  • It has
       h an ‘opt
             ‘ t out’
                   t’ from
                      f    the
                           th single
                               i l
    currency

The European Central Bank (ECB)

                    • ECB sets policy interest
                      rates for the sixteen
                      participating nations
                    • ECB objective is price
                      stability – defined as
                      CPI inflation of 2% or
                      below
                    • Countries joining the
                      Euro must meet the
                      convergence criteria

                                                 4
Convergence Criteria

• Inflation:
            – Average inflation over previous year must not exceed
              by more than1.5%
                       than1 5% that of the three lowest inflation
              countries
• Government Finances
            – Budget deficit must not exceed 3% of GDP
            – Gross government debt must not exceed 60% of GDP
• Interest Rates:
              A
            – Average  i ld on govtt b
                      yield             d mustt nott exceed
                                     bonds                  db
                                                             by more
              than 2% bond yields of three lowest inflation countries
• Exchange Rate Stability:
            – Currency must have adhered to fluctuation margins of
              the ERM in two previous years without severe tension

Euro Area and UK Policy Interest Rates
  Percent

                                                                        5
A2 Economics

Optimal Currency Areas (OCA)

 Is the Euro Zone an
 optimal currency area?

Is the Euro an Optimal Currency Zone?

• An optimal currency zone occurs when:
   – (1) Countries have achieved real convergence
   – (2) They respond in similar ways to external economic
     shocks or policy changes
   – (3) They have sufficient flexibility in both their product
     markets and labour markets to deal with these shocks
       • High geographical mobility of labour
       • High
           g occupational
                 p        mobility
                                 y of labour
       • Wage and price flexibility in factor markets
   – (4) Countries are prepared to use fiscal transfers to
     even out some of the regional economic imbalances
     within the European currency union

                                                                           6
Optimal Currency Zones (2)

• The Euro Zone is not an optimal currency zone!
     – The core group of EU countries are broadly similar
       (Germany + France + Netherlands)
     – Peripheral countries have big structural differences e.g.
       Ireland, Greece, Portugal and Spain
     – Response to interest rate changes varies across
       countries
     – And there are barriers to the mobility of labour
     – The Euro Area is a diverse group of countries and this
         k a one-size-fits-all
       makes        i fit ll monetaryt      li h
                                         policy      l diffi
                                                hugely difficultlt
     – Less of a problem during benign economic conditions of
       the late 1990s and first half of the last decade
     – But recent economic and financial turmoil has exposed
       weaknesses in the currency union

Optimal Currency Zones

   Highly                                                     Monetary Union
  Flexible                                                    Works

  Labour
  Market
 Flexibility

                 High risk
                 currency union
 Inflexible

                  Divergent       Real Economic Convergence     Convergent

                                                                               7
A2 Economics

  The Case for
  Entry into the
  Euro

Microeconomic Benefits of Entry

 (1) Potential Gains for consumers
  – Gains from price transparency
  – Reduction in the transactions costs
    of travelling within Europe (e.g. costs
    of currency exchange)
  – Cheaper mortgages if interest rates
    are lower

                                                        8
Microeconomic Benefits of UK Entry

 (2) Possible gains for businesses
      • Invoicing with just one currency
      • Lower transactions costs when
        trading
      • Stable currency and low inflation
        might allow businesses to fund
        their capital investment at lower
        real interest rates

                                       A2 Economics

 The Case for
 Staying
    y g Outside

                                                      9
Microeconomic Disadvantages

 (1) Changeover Costs from joining the Euro:
    – Menu Costs (vending machines, catalogues,
      f ki machines,
      franking   hi     postage
                           t
    – Customer confusion (imperfect information)
 (2) Higher prices
    – Potential loss of consumer welfare if suppliers
      increase prices when converting from sterling to euro
 ((3)) Lost instruments of p
                           policy
                                y adjustment
                                    j
    – Problems of a one-size fits all policy rate
    – Retaining the option of making an exchange rate
      adjustment is useful

Recent performance of the Euro Area

                                                              10
Comparing growth rates – UK & Euro Area
Percent

Germany - the largest country with the
Euro - a driver of policy decisions?
   Percent

                                          11
2000=100

           Convergent Economic Cycles?

Low real interest rates stimulated an
unsustainable boom in some countries

                                         12
Ireland boomed but over-heated

A similar story in Spain – now
unemployment soars as recession bites
 Percent

                                        13
One currency – but different inflation rates
    1996=100

And diverging unit labour costs – which
affects competitiveness in Euro Area
Index

                                                 14
Percent
                                    UK and Euro Area Inflation Compared

                                       What about unemployment rates?
Per cent of the labour force

                                                                          15
Percent
               Unemployment in Spain and Ireland

          Some EU states are not ready to join the
          Euro – E.g. interest rates still Poles apart
Percent

                                                         16
Some countries have pegged their
currency to the Euro
   EUR/EEK
   EUR/LVL

Fiscal Crisis: A Growing Debt Problem
PERCENT

                                        17
The Euro floats against the US Dollar
USD/EUR

And against UK sterling
   EUR/GBP

                                        18
Challenges facing the Euro Zone

Stresses and challenges facing Euro Area

1. Little common fiscal policy
   –   Big differences in size of fiscal deficits and debt levels
   –   Fiscal stability pact has effectively collapsed
   –   Growing risk of one or more Euro Area countries
       defaulting on some of their debts
   –   Will Euro Area nations bail out fellow members?
   –   Years of fiscal austerity for some nations will create
       deep economic and social pressures
2. Doubts about the likely strength of recovery
   –   Unemployment high and rising
   –   Rising cost-push inflation could lead to higher interest
       rates and choke off confidence as recovery starts

                                                                    19
Longer-term challenges

• Growth and employment creation in the Euro Area
  has not been noticeably higher than in countries
  o tside the ccurrency
  outside        rrenc union
                        nion
• 2008-10 crisis has highlighted the problems of
  setting a common interest rate for 16 nations
• Larger economic imbalances within the 16 nation
  currency union over wage levels, trade balances
  and
  a dpproductivity
        oduc     y will a
                        also
                          so need
                              eed to    addressed
                                   o be add essed if
  the Euro Zone is to avoid future crises
• Several weaker countries have become
  uncompetitive inside the Euro and this requires
  painful corrective policies which will be unpopular

                                                        20
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