Connecting the Dots
A United Europe: Problems and Prospects
The January 1 launch of the Euro, the common currency uniting eleven European countries, represents the most dramatic change in the international monetary system since the breakdown of the Bretton Woods agreement in 1971. For the first time in modern history, a group of independent countries have voluntarily decided to give up their national currencies, pool their monetary sovereignties, and create a currency of international significance. The transition to the new economic order will lead to a massive realignment of currency preferences in international banking, capital market, and trade. The Euro may pose the first credible challenge to the US dollar's dominance of international trade and finance.
After four decades of negotiating that began when the European leaders signed the Treaty of Rome in 1957, the European Monetary Union (EMU) has come into being. In one stroke, eleven countries - Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain - have replaced their national currencies with a new one. During the next three years, national currencies will continue to exist, but as subdivisions to Euro. In the beginning of 2002, Euro banknotes and coins will replace national banknotes and coins as legal tender.
The European Central Bank, based in Frankfort, stands at the core of the EMU. It is the central bank for the monetary union and the sole issuer of the Euro. The bank's main objective is to ensure price stability and set short-term interest rate in order to attain this objective.
Contrary to popular perception, national central banks will continue to exist and will play an important role under EMU. Together, the European and the national central banks will form the European System of Central Banks (ESCB), whose operation will be highly decentralised.
Although the formation of the EMU has now become mainly a political matter, but it is, after all, an economic idea. The economic rationale for the Union can be traced to the optimal currency area theory developed by Robert Mundell in the early 1960s.
The theory suggests that sharing a single currency across borders helps to reduce information and transaction cost, provide transparency of pricing, and enhance competition and greater certainty for investors. For the European Union, various estimates have put these gains at 0.5 per cent of GDP.
European countries have become more and more integrated in recent decades. Now, Europeans routinely sell goods and services across national boundaries, own stocks and bonds from other countries, and work abroad. But since each country has its own currency, Europeans spend lot of time and resources trading one currency for another. A common currency will not only save those countries time and money, but it will also increase trade within Europe as well as make it easier for citizens of one country to buy stocks and bonds in another.
The proponents of the monetary union have suggested that it will do much to integrate Europe's commodity, factor and capital markets. By increasing Europe-wide competition and revolutionising financial markets, it will encourage rationalisation, mergers and takeovers in the European banking sector and business firms.
However, monetary union also has costs. Although the introduction of a single currency will simplify trade between European countries, each country will give up the ability to use monetary policy to influence its economy. No individual country's central bank will be able to set interest rates. And no country in the EMU will be able to adjust its exchange rate vis-a-vis the others.
How large a sacrifice will it be to give up independent monetary and exchange rate policies? The answer depends on the types of macroeconomic shocks that hit the economy and how well other adjustment mechanisms compensate for the lack of exchange rate flexibility. In particular, it will depend on the degree to which labour can move across borders, and the extent to which fiscal policy can be used to control the economy.
The problem can be illustrated using an example of asymmetric shocks, economic changes that affected the members of the potential union differently. A shift of demand from the goods of region X onto the goods of region Y will increase unemployment in X while raising inflationary pressure in Y Expansionary monetary policy may help to reduce unemployment in X but it would worsen the inflationary pressure in Y; contractionary monetary policy would be equally destabilising for opposite reasons.
In this case, some have argued that exchange rate policy may provide a superior tool of adjustment. Assuming X and Y have different currencies, a depreciation of X's currency relative to Y's would simultaneously reduce unemployment in X and inflationary pressure in Y. A monetary union with a single currency rules out this solution. Because of asymmetric shocks, one country or region might be unlucky enough to get engulfed in a long and frustrating period of high unemployment that it could have avoided had it stayed out of the monetary union.
The optimal currency theory suggests three alternative responses to asymmetric shocks. The first is labour mobility - workers in the affected country must be able and willing to move freely to other countries. The second is wage and price flexibility - the country must be able to adjust wages and prices in response to an economic shock. The third is the presence of an automatic mechanism for transferring fiscal resources to the affected country.
Even a casual glance at these countries would indicate that none of these conditions is met in the proposed European Union. There are serious cyclical and structural variations among the economies in the Union. Moreover, interest rates are determined in different ways. Labour mobility is extremely limited not just between European countries, but within them too. Strong labour unions have also contributed to wage rigidity.
The absence of any enthusiasm for expanding the European Union budget to allow for big fiscal transfer presents a more serious problem. Estimates have shown that the European budget should be increased to 7 per cent of their GDP in order to enable it to play a more substantial stabilising role. But the majority of the Union members, under pressure to cut government spending at home, are not willing to let the budget rise above its present ceiling of less than 2 per cent of their combined GDP.
Since the early 1990s, the structural problems of Europe have worsened. Unemployment has continued to increase. Particularly, France and Germany - the driving forces of European integration - are not well prepared to cope with the rapid structural change and the stiffer competition in a monetary union. It is clear that monetary union will not resolve the unemployment problems of Europe, which are caused by excessively high tax rates, overregulation of the labour market, and social safety net provisions that have compromised fiscal solvency.
The possibility of a financial turmoil also threatens the proposed union. EMU will dramatically increase the degree of capital mobility within the euro area. Today European capital markets are still relatively closed. The complete elimination of foreign exchange risk following the introduction of the euro and the removal of regulatory constraints on the holding of foreign assets will change that.
Against the background of this dramatic liberalisation, the regulatory and institutional environment will not be adapted. This will make it difficult for regulations to assess the risk of the institutions under their jurisdiction. Moreover, financial institutions in each country in the union will, at least initially, be overwhelmingly national. This segmentation will make it very difficult to efficiently spread the risk of asymmetric economic shocks.
Interestingly, the opening up of the domestic market, the perception of low risk in moving funds from one market to another, and the lack of regulatory control are cited as the factors that led to the recent financial crisis in Southeast Asia. Hence the conditions for a similar financial turmoil, though remote, cannot be ruled out for the European Union.
Monetary unions of politically independent, large sovereign nations can fail, particularly when there is an external shock leading to a change in the economic environment. It is easier for unions to survive when the economic cycle is favourable.
A changeover to a new single currency will not be a simple process. It will require both a mental as well as an emotional transformation for each of the 400 million people in the European Union. Accustomed to valuing and transacting in national currencies that has always been an important component of political sovereignty, the abrupt change to a single currency may be deemed by many as a loss of national heritage.
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