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Question 2: Has the Euro been an economic success story so far? Or would its member states have been better off economically by not joining? Discuss. Historical Background: The adoption of the Euro and the establishment of the European Monetary Union are two of the latest steps in the effort to unify the European continent; an effort that started with the founding of the European Coal and Steel Community in 1952 (Europa online source). As we read from Baldwin and Wyplosz (2006) the road to the adoption of Euro was a long one starting early in the 70s. The most important step was taken in 1991 with the signing of the Maastricht Treaty. The participating members agreed upon the adoption of a common currency on the 1st of January 1999. In 1999 the euro was introduced for the first time in a virtual form for cashless transactions and accounting purposes (Europa, Online source). The first banknotes and coins were introduced in 2002. At this point of time Euro-zone has 16 members: Belgium, Spain, Ireland, Germany, France, Italy, Luxembourg, Netherlands, Portugal, Austria, Finland (1999), Greece (2001), Slovenia (2007), Cyprus, Malta (2008), Slovakia(2009). (Europa, Online source) It will be useful, in our evaluation of the Euro, to mention some concerns raised mainly by Germany before the signing of the Treaty. While some countries for decades had shown Monetary discipline
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achieving a low and stable

inflation rate, other countries had failed to do so. This could create problems to the European Central Bank since in a common currency environment, trying to
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Baldwin and Wyplosz, 2006

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fight inflation in some countries could create adverse effects to countries like Germany who at that point had a healthy economy. For this reason the adoption of euro is not an automated process, but the countries who wish to join the Euro-zone need to fulfill some criteria. Briefly these criteria are: Inflation rate should not exceed the average of the three lowest in the Euro-zone by more than 1.5%, interest rates should not exceed the average of the three rates of the countries with the lowest inflation rates, be a member of the Exchange Rate Mechanism for at least two years i.e. Do not devaluate its currency with respect to future partner currencies. Also budget deficits and Public Debt should not exceed the 3% and 60% of the GDP respectively. (Baldwin and Wyplosz, 2006)

Why was the Euro created? Apart from tightening the binds between member states, joining the Eurozone of course offers many other benefits, at least theoretically, otherwise countries would not had been willing to take such a large and risky step. One of the most important benefits is the significant reduction in transaction costs. Before the introduction of the euro, firms and individuals were spending significant amounts when converting their money from one currency to another, for traveling or for doing business. Now with the use of only one currency, firms and individuals doing business within the Euro-zone borders do not bare this cost. (Baldwin and Wyplosz, 2006). This is also very beneficial for tourism.

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Another significant advantage of the common currency is the elimination of exchange rate risk, which undermines the trade between different countries. Without this risk present, trade should improve greatly boosting economic growth. Another important aspect is the transparency of prices. Euro-zone citizens/firms can now clearly see which products are cheaper and better for them. Firms can now import raw materials from countries within the Euro-zone, according to a value-quality criterion, easier than before. This transparency gives rise to a cross border competition with the benefits of lower prices, better quality and an increase in production efficiency inside the borders of Euro-zone. Baldwin and Wyplosz, 2006 The required discipline, in exercising monetary policy in order to be granted entry into Eurozone and the commitment of the European Central Bank to keep inflation close to 2% are expected to keep inflation rates low and stable. In this environment expectations about inflation and interest rates are also expected to be at low levels. Baldwin and Wyplosz, 2006 The introduction of Euro could lead to a more efficient financial market. Firms and individuals can invest through out the euro area in order to get the best returns on their investment; they have more options to diversify their portfolios and they can also borrow where the cost is the lowest. The tougher competition between banks (more banks compete now) can lead to a reduction in transaction costs which encourages more investment by firms and individuals and thus higher economic growth and employment2.

European Commission: Why the Euro? , Single Financial Market. Access online at: http://ec.europa.eu/economy_finance/the_euro/why_euro9329_en.htm

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Criticism The main concern of eurosceptics is how the ECB will react in the case of an asymmetric adverse shock, i.e. an adverse shock that does not influences all member states in the same way. In this case trying to fight the effects of the shock in one country can lead to adverse effects in other countries that did not have problems prior to the ECBs decisions, or it can make existing problems more persistent. (Baldwin and Wyplosz, 2006) Some economists suggest that, by giving up their own currencies and so the right to independently exercise monetary policy, countries will not be able to fight effectively adverse shocks and the effects will last longer. For example in a recession where investment and consumption are falling a Central Bank might want to devaluate its currency. This way, domestic products become more competitive and exports will increase acting as a cushion to the reduction of consumption and investment. Horvath and Komarek (2002). Finally there is a concern whether or not different member states will agree on the way monetary policy should be implemented in order to achieve the common target of an inflation rate close to 2%. Frequent disagreements will result in a dysfunctional ECB, in an environment where Central Banks need to be flexible and quick in their decisions. An area is able to enjoy the benefits of a common currency and avoid the costs of adverse shocks only if it is an optimum currency area. The criteria for an OCA are mentioned briefly below: From Bergman:

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Iosif Iosif Mundell criterion: In an OCA there must be perfect capital and labor mobility. Kenen criterion: Production and export diversification. McKinnon criterion: When countries are very open to trade and trade heavily with each other they form an OCA. Fiscal Transfer Criterion: Countries agree on financially helping each other in the face of an adverse shock Homogeneity of preferences criterion: Currency Union members must share a wide consensus on the way to deal with shocks. Solidarity Criterion: National interests and benefits must be sacrificed in the name of common destiny.

Evidence: The costs and benefits mentioned before are of theoretical background. In this section we analyze the evidence available to decide whether or not Euro has been a success so far. Budget balance/National Debt: In order for countries to be allowed to join the EMU, their budget deficit must not exceed the 3% of the GDP and the National Debt must not exceed 60% of the GDP. How well have the Euro-zone members have performed? Table 1

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From table 1 we can see that most of the EU-15 countries manage to maintain a budget deficit under the 3% of the GDP limit. The exception in this case is Greece whose deficit as a percentage of the GDP was -3.5% in 2007. This is not bad if we consider that the ratio was -7.5% in 2004. Some of the EU-15 countries like Finland for example manage to maintain a surplus for some years now while seven of them registered a surplus in 2007. The budget deficit for the Euro area was 0.6% of the GDP in 2007 compared to the 1.3% in 2006. The deficit of EU27 was slightly higher at 0.9%. For comparison the UK budget deficit was higher than the EU-15 and EU-27 average, at -2.8% of the GDP but still below the benchmark of 3%. So from this perspective we can say, the euro is doing well so far. Table 2: Public Debt

Source: ECB Monthly Bulletin On the other hand the public Debt for the EU-15 is beyond its 60% limit at 66.3% of the GDP. The good news is that there was a fall compared to 2006 when the Debt was at 68.5% On the other hand the Debt of the EU-27 was recorded to be 58.7% of the GDP. As Patterson (2006) suggests this is not necessarily bad news. Eight of the EU-15 countries maintained a debt below the

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60% target while the rest of them are only slightly higher. The only outliers are Greece and Italy that for many years register a debt close to 100% of the GDP pulling the average higher. The UK is doing much better than the EU-15 and EU27 average with a national debt at 44.2% of the GDP. As Patterson (2006) reports what really matters in this case is the sustainability of the government financial position. The main indicators for this are the yield spreads on different long-term government bonds, which indeed apart from a small period in 2005 (Greece, Italy, Portugal) were narrow. He also points out that 91.6% of the government debt is long-term indicating that governments are not borrowing because they are in a difficult financial position. Inflation Rate: The main monetary target that the ECB pursues is an inflation rate close to 2%. Maintaining an inflation rate low and stable would also keep expectations about inflation at low levels. This would create an environment with less uncertainty giving an incentive for more investment and thus growth. The Governor of the Bank of France in his speech in 2006, reports that the inflation target was met successfully; inflation is below but close to 2% over the medium run. Diagram 1:

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From Diagram1 we can see that the inflation rate in the period starting in the first Quarter of 2002 until the third Quarter of 2007 fluctuates very close to 2%. We neglect the period after 2007 since it consists a special case and we will discuss it later on. One of the main concerns of eurosceptics is how the ECB can achieve its monetary target since the nominal interest rates it sets, translate into different real interest rates in every member state due to inflation differentials. Euro supporters answer that in time, the unified market and the intense competition will lead to a convergence of the inflation rate across all member states and the problem will seize to exist. Diagram2 provides some evidence that these claims can be correct. In the period prior and until 1998 inflation rates across the euro area seem to converge, but after 1998 there is a great difference between them. They start coming together again in 2002. Patterson (2006). Overall we can say that euro is exhibiting success in this aspect aswell. One of the greatest examples in this case is Italy. Italys effort to meet the requirement of low inflation (and also the credibility associated with the eurozone membership ) lead to a significant reduction in the Italian interest rate, thus

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making it easier for the government to repay its high debt. (Baldwin and Wyplosz, 2006) Diagram 2: Inflation rates in the Euro area 1996-2005

Source: Patterson (2006)

Unemployment: The euro area is accused by a lot of economists, especially in the UK that it is performing very poorly in fighting unemployment. The average

unemployment rate fluctuates close to 8% percent and in the period starting from 2002 until 2005 it reached 9% (Eurostat, online source) in contrast to the USA and UK unemployment rate which moved below 5% in the period before the recent crisis. (Trading Economics, Global Economic research, online source) Diagram 3

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Source: Eurostat In my opinion this high unemployment cannot be attributed solely to the ECBs choice of actions aiming at maintaining price stability. A lot of countries achieve unemployment rates much lower than the high EU-15 average. So we can say that this high average can be due to country specifics and governments choices as well. Also as Patterson (2006) reports, since this unemployment rate is observed in a period of price stability someone can argue that it is the Natural Rate of Unemployment of the Euro area. GDP Growth Rate: The Currency Union exhibits very low growth rates compared to its competitors the UK, Japan and the USA. As Diagram3 shows the GDP growth rate for the Currency Union exceeded 4% only for a short period in 2004 and most of the time was significantly below 3%. Again according to Patterson (2006)

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this can be attributed to country specifics and not necessarily to ECB policy since some member states (e.g. Greece, Ireland) exhibited high growth rates in contrast with the average. He also suggests that the difference in growth rates between USA and the EU can be due to the higher population growth in the former since the GDP Growth per head is almost the same. Diagram 3:

Did the changeover cause prices to rise? Ranyard (2007) reports that 82% of the Euro-barometer respondents believe that most business took advantage of the euro changeover to hide increases in the prices of many goods. Surveys conducted following these claims showed that the prices rose for some goods but ongrand scale inflation did not rise since competition lead to a decrease in other goods. Therefore any claims that the transition to euro alone can cause an increase in inflation are false. The Euro and other Currencies: The general public impression is that Euro is a strong currency and it has done very well compared to its competitors. This has not always been the case

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but even so appreciation of one currency against others is not necessarily a good thing. When the Euro was first introduced in 1999 its value against the Dollar fell. At that point in time oil prices were rising sharply and as a result inflation aswell. This depreciation of the euro made the economic situation worse for the member states since oil prices became even more expensive. In 2000 euro started rising against major currencies but in a period of economic slowdown thus making euro area countries less competitive (more expensive products). This story repeats itself in the current period. Euro has appreciated especially against sterling again making EU-16 products less competitive during a recession. Baldwin and Wyplosz (2006)

Current Financial Crisis: According to BBC (2008) Eurozone has officially entered in recession after two consecutive quarters of negative growth. The main reason for that is Germanys passing into recession which drove the whole eurozone with it since Germany is the strongest economy in the Union. Most of the countries in the EMU also saw their growth rates falling. The forecasts for 2009 even though are not clear yet show that the recession is going to continue. Entering in recession does not prove that countries would be better off by not joining since US, Japan and the UK also experienced a significant reduction in growth rates and a rise in unemployment. It proves that Eurozone membership does not necessarily shield from adverse shocks. The positive insight is that none of the country members

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went bankrupt, while countries outside the Union have, with Iceland being the best example. Conclusion The economic conditions following the introduction of Euro were very hard for the new currency. But under these difficult conditions the Euro not only managed to survive, contradicting all those who believed that the idea of a common currency was very risky, but it also performed very well. The main target of stable and low inflation was achieved and the interest rates were kept at a suitably low level to encourage investment. Also Budget deficits were kept at levels below the 3% of the GDP target. The national debt of most countries is kept below the 60% of GDP with only Greece and Italy driving the EU-15 average above its target. The high EU-15 unemployment levels and the low growth rates as we have seen can be attributed to countrys specifics and not to the Union, since many of the member states achieved low unemployment rates and high growth rates in contrast to the average. The only real disadvantage of the eurozone in my opinion is the movements of the exchange rate during a crisis. We have seen the exchange rate moving in directions that are likely to prolong recessions or exercise inflationary pressures. Someone cannot answer with certainty the question if countries would be better off by not joining the eurozone. Eurozone has offered many advantages to its member states but also some disadvantages. Up to this point there is no evidence that entering the Union has made any country worse off. On the

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contrary there are examples of countries e.g. Italy, that were significantly benefited from joining. We can neither suggest that not joining is a wrong decision. The UK economy for example has performed as well as the EU-15 and sometimes even better. We should not forget that euro is a young currency and perhaps the data we have up to this date is not enough to evaluate it correctly. In the next decade we will have a better picture about the euro and perhaps we will be able to answer with certainty to this important question. References/Bibliography: 1. Arthur I. Cyr (2003), The Euro: Faith, hope and Parity, International Affairs Vol. 79, p 979-992 2. Baldwin R. and Wyplosz C. (2006), The Economics of European Integration, McGrawhill, 2nd Edition 3. BBC News (2008), Eurozone officially in Recession. 4. Bergman M. The Optimum Currency Area Criteria, University of Copenhagen 5. Europa, Eurostat, Access online at:

http://epp.eurostat.ec.europa.eu/portal/page?_pageid=1090,30070682,10 90_33076576&_dad=portal&_schema=PORTAL 6. Europa, the History of the European Union. Access online at: http://europa.eu/abc/history/index_en.htm 7. European Central Bank (2008), Eurosystem, Monthly Bulletin 8. European Commission: Economic and Financial Affairs The Euro. Access Online at: http://ec.europa.eu/economy_finance/the_euro/index_en.htm?cs_mid=294 6

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9. European Commission: Why the Euro? , Single Financial Market. Access online at: http://ec.europa.eu/economy_finance/the_euro/why_euro9329_en.htm

10. Horvath R. and Komarek L. (2002), Optimum Currency Area Theory: An approach for thinking about monetary integration, Warwick Economic Research Papers 11. Noyer C. (2006), Is the Euro a success story? Governor of the Bank of France, at the Paris Europlace International Forum, Tokyo 12. Patterson B. (2006), The Euro: Success or failure? European Movement 13. Ranyard R. (2007), Euro Stories: The Irish Experience of Currency Change, Springer Science + Business Media, p 313-322 14. Trading Economics, Global Economic Research. Access Online at: http://www.tradingeconomics.com

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