The Euro And Its Effects Essay, Research Paper

Since World War II, Europe has been moving toward integration. With the creation of the euro, they have made a giant step toward uniting Europe for good. The euro will have immediate benefits. People traveling or simply shopping among participating European nations will immediately benefit from being able to compare prices for similar goods without needing a calculator. Not only will the exchange rate become irrelevant, but the costs of converting between currencies will also be eliminated. Because of the savings related to currency conversions, one-third of firms expect short-term earnings gains from the introduction of the euro, and three-quarters expect long-term benefits to the bottom line. The euro will make life easier for the people of Europe.

The Maastricht Treaty mentions EMU and refers to it together with the Single Market as one of the means by which the Union will promote economic and social progress that is balanced and sustainable. The treaty refers to the irrevocable fixing of a single currency, the ECU, and a single monetary policy and exchange rate policy.

The first stage began on 1 July 1990 with the removal of exchange controls in 8 of the then 12 Member States, the inclusion in principle of all currencies in the narrow band of the Exchange-Rate Mechanism (ERM), and measures to encourage convergence. No new institutions were required. The second stage began on 1 January 1994, with the newly created European Monetary Institute (EMI), based in Frankfurt, gradually assuming a coordinating role.

Those countries that qualified undertook stage 3 of EMU in early 1999. At the beginning of Stage 3 the participating states adopted the ‘irrevocably fixed’ rates at which the Euro was to be substituted for national currencies. Stage 3 also entailed the creation of a European System of Central Banks (ESCB), composed of the European Central Bank (ECB) and representatives of the national central banks.

The value of the euro will be determined by economic conditions in the euro area and particularly by maintaining price stability. Countries will only be allowed to join Economic and Monetary Union when their economic conditions have converged toward those in the euro area so that their entry should not impact significantly on the value of the euro. During a three-year transition period, 1999-2002, European companies will convert their accounts to euros. Then, in 2002, euro notes and coins will be circulated in the different countries. There will, of course, be much bickering over the use of national symbols (should the queen’s head be conjoined with the body of a bird?), or whether coin sizes will fit into national telephones and vending machines.

In May 1998, bilateral exchange rates between participating currencies were introduced. This was done to help guide the financial markets in the time up to the launch of the euro on January 1, 1999 by indicating that the bilateral rates were the proper economic basis for determining the irrevocable conversion rates between the euro and participating national currencies. The currencies not participating in the euro area from the outset did not have fixed exchange rates, either against the participating currencies or against the euro. Presently, they may participate in a new exchange rate mechanism, which will define central rates against the euro with a standard fluctuation band of up to 15% around that central rate.

With the Jan.1 launch of the euro, the common currency uniting 11 countries, Europe posed the first challenge to the U.S. dollar’s dominance of international trade and finance. The euro should not be confused with the European Currency Unit (ECU), which was a just a basket of currencies tied together. The advent of European economic and monetary union, known as EMU, doesn’t just change the world’s financial landscape; it could also alter the global balance of power. That means stock exchanges will trade in euros and large businesses will keep track of finances in the euro. To ease the transition, bank customers can keep accounts in euros. The size of the new currency bloc — with 290 million inhabitants — will provide a stable economic and business environment. The EMU gives birth to a market as big as the United States and backed by a single currency. It represents twenty percent of world economic output and eighteen percent of world trade. The euro could quickly lead to huge capital flows in Europe, making the European firms more competitive in the global marketplace. Businesses will save money; the costs of changing currencies from country to country will be sharply reduced. Comparing prices will be quicker and interest rates will stabilize. All this will make long-term planning easier. The member countries are Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain.

There have been questions about the EMU’s strength and sustainability. In part, this plan forces governments to give up a measure of sovereignty over their economic affairs. The United Kingdom, Sweden, and Denmark are staying out of the EMU for this reason. Some critics say that the euro is being introduced forcibly and may cause conflict because of the political instability. According to Antonio Martino, the former prime minister of Italy, political unification has always preceded monetary unification (Wall Street Journal 1/4/99). The road to economic unification under the EMU has led the member countries in terms of budget deficits and inflation. However, they are still widely divergent. For example, Ireland’s gross domestic product (GDP) grew about 8.5% in 1998, while Italy’s GDP only grew 1.5%; and yet, both will have the same EU benchmark interest rate of 3%. This interest rate is tailored more to the needs of the EMU’s core countries, France and Germany. The EU countries are also ceding their monetary policy to the ECB and submitting to a Growth and Stability Pact that limits their ability to build up debts or deficits.

EMU members are sacrificing monetary and exchange rate independence and flexibility to the new European Central Bank (ECB). The ability of individual countries to handle economic shocks, such as falling external demand for their products, will be compromised. Even when in place, EMU will likely have to contend with internal dissension over macroeconomic policies. Strains could develop between member countries growing at different economic growth rates for which a “one size fits all” monetary policy is inappropriate. Some countries, especially those with more trade with non-EMU countries, will be more affected than others by exchange rate policy and may complain about “overvaluation” of the euro. In countries for which the “core” monetary policy is too severe, chronic slow growth and high unemployment could reduce public support for continued EMU membership. The ultimate test of EMU will be ensuring unity.

The euro will affect monetary functions in a number of ways. It has already come into use for non-cash transactions ranging from government bond issues to credit card and check purchases. Electronic transactions are also taking place in euros and both new and old government bonds will be denominated in euros. Consumers will better be able to assess products’ true costs without complex or bothersome calculations. Prices will be pushed downward as merchants no longer need to insulate themselves against risk arising from fluctuating currency values in multi-currency transactions. Euro figures are also appearing alongside national currencies on paychecks, phone bills and bank statements. Stock exchanges will trade in euros and large businesses will keep track of finances in the euro. The single currency encourages the development of a liquid capital market, lowering the cost of capital and improving its allocation. This should provide a boost to smaller companies that in the past have been forced to rely on domestic banks for credit, as well as result in a wider choice of securities at attractive prices for investors.

There will also be some problems in the euro switch over. One immediate effect of conversion to the Euro will be the short-term expense to banks and other businesses as they train personnel, adapt technology, update information systems, and otherwise achieve Euro compliance. Estimates of adaptation costs range widely. One consultancy, Cap Gemini, predicts that adaptation costs will range between 0.5% and 2% of a typical firm’s sales. Moody’s, a rating agency, estimate the cost of conversion at $100 billion. The Gartner Group, another consultancy, puts the cost at between $150 billion and $400 billion. The disparity of estimates reflects continuing uncertainty as to what precisely conversion will require. However, despite short-term costs, ultimately businesses and individuals will save by handling a single currency rather than many.

The euro eases economic restrictions in the bloc. It creates an environment in which prices, costs, and taxes become instantly comparable from one country to the other. Since it deprives governments of the possibility of devaluing their currency to help the economy, it increases pressure for tough structural reforms. Unable to devalue or spend their way out of recession, Europe’s mostly left-leaning countries will be forced to adjust things such as labor flexibility through these structural reforms. The euro will also make the “single European market” for goods and services more efficient by making both the prices of goods and services and the costs of producing them more transparent. This was supposed to happen as the “single market” was being developed but currency risk and other differences in countries’ financial conditions stymied taking full advantage of the single market.

With the greater transparency of prices due to the euro and the greater stability of converging financial conditions under EMU, proponents argue that efficiency gains are in store. Arbitrage, for example, would make it more difficult to keep the price for a good in one market above prices in other markets. Persistent production cost advantages would attract new production facilities whereas disadvantages would discourage new investment. This could bring a wave of production rationalizations, business restructurings and consolidation. The solidification of the single European market could finally usher in the sweeping business and institutional changes in Europe, which the architects of the single market hoped, would make European companies more competitive with U.S. and other foreign firms. International financial stability will also be supported by the strict internal budgetary policies that countries adopting the euro must follow. When governments must be accountable for returns on their investments, they tend to look more critically at what they do best, allowing others to take over inefficient state-run enterprises. Privatization gives an immediate boost to state coffers, while providing the private sector with opportunities to introduce competitively advantageous innovations. The money saved by running industries efficiently can provide money to be invested in new enterprises, creating new jobs and fueling further economic growth.

Currency markets transact over $1 trillion in foreign exchange operations every day. Once the Euro is introduced, these transactions will decline as ten currencies are eliminated from global markets, but they will be replaced by the increase in transactions between the euro and the dollar. A central aspect of currency markets is the role of the dollar as a reserve currency. Once the euro is introduced and accepted as an important world currency, more countries and corporations will keep their reserves in euros to increase currency diversification and reduce risk.

Eventually, EMU proponents say, the euro will become a world reserve currency, much like the dollar. It will take quite a while for the euro to become widely used as a reserve currency. People accept dollars for the same reason they accept gold, because they believe that other people will always accept them. There are several reasons for this belief. The size of the U.S. market and its ability to grow larger, which gives people confidence that they will always be able to buy with dollars valuable things that America produces. Another reason is faith, based on U.S. political stability and on the relative transparency of American political and financial institutions, that there will always be an U.S. government willing and able to redeem its dollar-denominated securities. Finally, a large enough supply of dollars in the world so that one can always buy and sell them. In part, there are so many dollars available because the United States has been running trade deficits for so long. For markets priced in dollars, the change may be slower, which could prove beneficial to the euro. The euro could be overvalued relative to the dollar, leading to a decline in European competitiveness and a rise in unemployment.

For the single currency euro to come anywhere near matching the dollar as a reserve currency, the world will have to be convinced of the durability and success of the single economy upon which it is based. One key question, therefore, is whether the euro will encourage faster European growth or will reinforce the austere macroeconomic policies that have resulted in high levels of unemployment. The answer, in turn, depends on whether the ECB can absorb the lesson of the recent American experience, which is that non-inflationary full employment can be achieved through sustained low interest rates. This is not just an issue for Europeans. If Europe cannot grow faster, the global economy may not be able to avoid another crisis – this one caused by the inevitable drop in the value of the dollar.

Being able to print 80 percent of the world’s hard currency reserves is an advantage. Because of it, the United States has had the unique capacity to run chronic trade deficits and still maintain a strong currency. U.S. consumers, tourists, investors in overseas markets benefit, and the U.S. military benefits because they can maintain foreign bases more cheaply. The costs go to U.S. workers engaged in tradable goods industries – primarily manufacturing. Among the most important factors determining the impact of the euro on the global economy over the next few years are whether the euro helps or impedes growth in Europe, and how soon and how fast the dollar declines.

However, bad policy decisions of the past may come back to haunt the EMU in the present. The ECB keeps interest rates higher than justified by unemployment in order to maintain credibility and investor “confidence” in the euro. Maastricht budget constraints also keep growth low. The ECB remains secretive so investors do not understand how it works and are, therefore, suspicious about the stability of the euro. Disagreements over the ECB’s policies among the member states could lead to a number of outcomes, all equally undesirable. They include:

+ Continued high unemployment in Europe.

+ The Euro stagnating at par with U.S. dollar, or below.

+ The European trade surplus with United States could grow.

+ European investment in United States is strong as European firms move to take advantage of growing U.S. market.

+ Social welfare erodes as slow growth reduces revenues and governments attempt to stimulate private sector growth by further reducing the public sector.

The drop in the dollar against the euro hurts the European trade balance. And because of years of slow growth, European firms are not in a good position to grow on the basis of domestic sales. Unemployment rises and pressure builds for European workers to accept lower wages to stay competitive. Whether the development of a strong euro would encourage the division of the world into warring “currency” blocs – the euro in Europe and Africa, a dollar bloc in the Western Hemisphere and eventually a similar single currency bloc in Asia. This is a possibility. But such a scenario will not be the result of a single European currency.

It will be the result of near-sighted policies. If European authorities do not encourage a strong and sustainable internal growth within Europe, if the U.S. policy makers see the euro as a rival to their current hegemonic influence, rather than as a potential partner in the task of maintaining global stability, and if both do not work together to produce a “soft landing” for the dollar, then stagnant growth will aggravate the competition for foreign markets and increase tensions between them. A collapse of the EMU and the euro is unlikely, but bad policy decisions could lead to decreased credibility of the euro as a world reserve currency.

Since its launch, the euro’s value has shrunk relative to the dollar. The euro has shriveled 17.4% in value since its introduction as investors fled to the greenback in search of better returns in U.S. stocks and bonds. The ECB’s one-size-fits-all monetary policy is now creating a huge Continental divide that could crimp Europe’s chances for economic convergence and non-inflationary growth. Booming countries on Europe’s periphery from Spain to Ireland to Finland need higher interest rates to tame a rising threat of inflation in their fast-growing economies, while the recovering economies of core countries such as Germany and Italy need all the help they can get from low interest rates.

The euro’s lowest point came on Feb. 28. There was a big sell order in Tokyo, which some market participants say was more than two billion dollars, the euro plunged 3.7% against the dollar to a record low of 93.9 cents. What Europe’s power brokers had forgotten is that currencies keep their value only when global investors are keen to hold them because they are backed by strong economies and central banks that inspire confidence. By that harsh test, the 15-month old euro is judged by many to be a flop and the European Central Bank a big disappointment.

At the time of its launch, European economies were in the doldrums at the time and vast amounts of capital were pouring out, approximately one hundred fifty billion dollars last year. Yet, even if that flow reverses, the system will still have a major flaw: Unlike the U.S. Federal Reserve System, the ECB is trying to operate a uniform monetary policy in an area that isn’t united politically and lacks a common fiscal policy. That means there are no automatic adjustment mechanisms, such as budgetary transfers or easy migration, to salve economic hardship or defuse political problems in any hard-hit region.

The ECB is hardly to blame for a system set up by its political masters. But the way the bank works compounds the problem. The ECB gives the impression of weak leadership under its president, Wim Duisenberg, thanks to his consensual management style. The bank’s other five full-time executive committee members often disagree in public. And the 11 heads of member countries’ national central banks, which with the committee make up the bank’s 17-member rate-setting governing council, sometimes behave as if they still ran an independent monetary policy.

Now, the bank needs to win the respect of the markets. It won’t be easy, because the bank has saddled itself with two measures to decide what key interest rates should be. The so-called twin-pillar approach mandates the bank to consider both money-supply growth and a broad-based analysis of inflationary risks when setting rates. That’s asking for trouble because the two measures could easily send contradictory signals. Indeed they do. Since the euro’s launch, broad money-supply growth has been consistently above the bank’s 4.5% target — indicating that higher rates are needed. But, until very recently, inflation has been well under the 2% upper limit that the ECB set for Europe — suggesting that steady or lower rates were required, especially against a background of anemic growth and high unemployment.

Despite its travails, though, the ECB has scored some notable successes. The euro zone’s 11 national money markets have been stitched together into a seamless whole. The ECB’s Europewide payments system works without a hitch. And the euro is a clear No. 2 behind the dollar and ahead of the yen as a reserve currency. International companies issued more bonds denominated in euros than in dollars last year. All the same, growing concern in financial markets about the ECB’s performance is eroding its credibility. The euro’s big swings are sapping public confidence and deterring investors. Instead of controlling the markets, the ECB sometimes seems to be controlled by them. Some analysts, for instance, figure the ECB was railroaded into jacking up its rates on Feb. 3 to 3.25% from 3% by the euro’s chronic weakness.

The final objective of the ECB’s policy will be price stability. In the pursuit of this objective, the ECB will need to develop an appropriate monetary policy strategy. In its Report, the EMI confines the list of possible strategies to just two, namely monetary targeting and direct inflation targeting. The final decision on which – or which combination of – the two strategies will be used will be taken by the ECB in 1998.

Monetary targeting is based on the assumption that, in the long run, inflation is a monetary phenomenon. If a stable relationship exists between money supply and inflation, price stability can be achieved/maintained indirectly by controlling the supply of money. The crucial feature of this strategy is the existence of a broadly stable relationship between money supply and prices. Although preliminary evidence is encouraging, uncertainty remains as to whether structural adjustments linked to the introduction of the single currency might undermine the money supply/price relationship and so reduce the effectiveness of monetary targeting as a means to control inflation.

With respect to inflation targeting, the focus of monetary policy is on the future expected inflation rate. A wide range of indicators is used to predict the outlook for inflation in a future period (say, 1 or 2 years ahead), and monetary policy is adjusted accordingly. The crucial feature of this strategy is a stable relationship between aggregate demand in the economy and prices i.e. whether, on the basis of the available information on economic performance, the ECB will be able to make an accurate assessment of future inflation. Once again, the structural adjustments implied by the introduction of the single currency may undermine the stability of such relationships making the use of direct inflation targeting less effective as a monetary policy framework.

The differences between these two strategies are smaller than they may appear. Within a framework of monetary targeting, the overriding policy objective remains price stability; thus, if for some exceptional reason (e.g. a major structural change) money demand is seen to increase without implying inflationary pressures, the money supply will be allowed to breach the target range. Similarly, within a framework of direct inflation targeting, money supply will certainly be among the more important indicators used to measure potential inflationary pressures. Hence, whichever strategy the ECB will choose, the implementation of monetary policy by the ECB is likely to be rather similar.

At the world level, the euro will eventually bring great benefits. US companies rarely have to bear an exchange-rate risk. Whether their customers or suppliers are situated in Russia, Argentina or China, their invoicing is almost always in dollars. European firms will in future benefit from the same type of advantages with the euro. They will be able to invoice in the currency in which their costs are expressed. They will thus be better placed to face world competition. Their efforts to boost productivity will no longer run the risk of being nullified by a currency shock.

Furthermore, the euro’s arrival will constitute a major change in the international monetary system. That system is currently dominated by the dollar. By the end of 1995, about 50% of world exports were invoiced in dollars, whereas the United States accounts for only 19.6% of world trade (20.9% for Europe). From 1999 the euro will give Europe a monetary importance consistent with its economic and commercial role.

The euro will also enable firms to make direct savings in terms of foreign exchange conversion and hedging costs; the gain is estimated at ECU 30 billion a year. This will be supplemented by a considerable simplification of cash management and in particular, although this benefit is not quantifiable, by a higher confidence in investment decisions. These benefits will be connected with firms’ European activities but they will also reinforce their competitive position in the world export market.

The European Union has made a giant leap with the adoption of the euro. It has experienced some turbulence, but with sound policies and a willingness to work through any future problems, EU can ultimately prosper. The euro has caused a new financial optimism in Europe and around the world. If the EU can integrate its member nations’ financial policies, the euro will be second only to the dollar. Time, ultimately, will show the outcome of all the work put into ensuring the continued health of the euro and the EU member nations.