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The Euro Mistake: The Good, The Bad, and Potential Solutions

The Euro Mistake: The Good, The Bad, and Potential Solutions

Introduction and Background

The Economic and Monetary Union (EMU) consists of a single currency, the Euro, and the Eurosystem, made up by the ECB and national central banks of Euro member states. The Euro, introduced in 1999 in 12 states that “abandoned their national currencies in favour of a European alternative” had been in development since 1992 . It now covers 19 EU member states, and for the first time since the Roman Empire, much of Europe has one currency. Member states control their national budgets and structural policies while staying within deficit and debt limits the EMU imposes.

The European Central Bank (ECB), the central bank for the Euro controls monetary policy.  Its primary goal is price stability but is also responsible for defining and implementing euro area monetary policy, foreign exchange operations portfolio management, and smooth payment systems in addition to other tasks . Despite the many benefits of the Euro, the European Monetary Union (EMU) was a mistake because the negatives, such as asymmetric shocks, outweigh its positive effects, like greater economic integration. However, dismantling the Euro would create substantial economic setbacks and is not a viable option, meaning the Euro will remain regardless of its problems.

 

Benefits of a Single Currency

The Euro, despite its controversy, has played an important role in the development of the EU’s economic integration. Its introduction lowered barriers to trade, which increased competitiveness of and trade between Eurozone businesses. Business contracts are no longer subject to exchange rate uncertainty, increasing certainty and investment while lowering business’ capital costs . The Euro has not only stimulated trade, but also the free movement of capital, goods, and people.

The Euro has also strengthened the EU’s single market. The introduction of the Euro increased transparency and allowed simpler comparison of cross-border prices. With transparent prices, it is easier to see whether the EU single market has achieved price convergence, indicating the level of market integration. Eurozone states will cooperate more closely with one another to create a stable currency and economy, thus making the Euro a “tangible sign of a European identity.” Additionally, countries around the world are using the Euro for reserves, and some are even pegging their currencies to the Euro, demonstrating the importance of the Euro and the EU as a global economic power. Since the introduction of the Euro, there has been a “stronger presence for the EU in the global economy”, and the Euro is “considered a viable alternative global reserve currency and competitor to the US dollar” (564).

The Euro was a major political accomplishment of EU member states, and politicians and citizens believed that the Euro “would lead to peace and prosperity”. The recent economic crisis proved that the Euro, in fact, heightens asymmetric shocks due to the lack of cyclical correlation. Overall, “the euro is an integral part of the economic, social and political structures of today’s European Union”, but was ultimately a result of political desire for more European integration rather than an economic motivation.

 

Negative Effects of a Single Currency

The Euro created a loss of economic sovereignty and individual monetary policy, making it difficult to respond to national economic problems. The ECB sets monetary policy even if it helps some countries while hurting others in order to act based on “what is good for the whole Euro zone, rather than any individual economy”. Individual exchange rates can no longer respond to national economic booms and busts, but rather, the Euro exchange rate responds to the Eurozone as a whole. Eurozone countries can neither devalue their currencies nor use interest rate policy in order to achieve their national objectives. Additionally, the Euro weakened “the market signals that would otherwise warn a country that its fiscal deficits were becoming excessive”. Although countries willingly gave up their right to control monetary policy, the Euro has had an overall negative effect on the economy of many, if not most, Eurozone countries.

For instance, Greece is suffering at the expense of the Euro. Although Greece began failing before the financial crisis, European authorities failed to intervene at the first sign of trouble. The introduction of the Euro lowered interest rates in Greece, who previously had high interest rates, which increased borrowing, leading to more problems. A “Grexit” might end up improving the Euro credibility because it would remove a member who “should never have been allowed to join in the first place”. The ECB was not supposed to bailout countries, so Greece had to choose either to leave the euro or achieve an unsanctioned bailout. Without borrowing from other Eurozone countries, Greece would have failed to pay its national debt or other payment obligations such as salaries or pensions.

The EU and EMU economic governance has been unsuccessful. Despite the fact that the Euro helped capital movement within the EMU, it led to the funding of bubbles like the property bubble in Ireland and many Eurozone countries still have other barriers such as intense administrative regulations, immovable labor markets, and high business expenses. If individual states have negative economic indicators, they can cause an overall euro depreciation. Finally, the Euro was supposed to increase price transparency and bring about a single price, which it has not yet done.

 

Optimum Currency Area

An optimum currency area is “a phrase used in economic theory to define the geographical area in which the conditions are most favourable for sharing a single currency.” A single currency implies imposing a single monetary policy, meaning countries must be similar in order for all to benefit.  One monetary policy is only appropriate if countries have similar economies and similar economic cultures. In order to have similar economic cycles, member states must have similar shocks, institutions, and policies in addition to economic integration. If a currency union does not have synchronized business cycles, “the common monetary policy does not satisfy the needs of all and may even contribute to cyclical divergence,” which the Eurozone has been experiencing.

The convergence criteria in the Maastricht Treaty of 1992 addressed exchange rate, inflation, and interest rate stability as well as debt and deficit limits in the attempt to create an optimum currency area; however these convergence criteria should have also considered economic structures, cycles, and political culture. This condition of similarity in the optimum currency area theory implies that “countries suffering from asymmetric shocks should not yet join the eurozone,” which the convergence criteria did not address, thus leading to problems.

There are two main groups in the Eurozone with opposite business cycles: the north, or core, and the south, or periphery. The core wants the periphery to take on economic reforms and has allowed the ECB to provide relief to struggling countries in the periphery. Although reforms in the periphery could help the Euro, the main challenge is whether those countries will do what is necessary and whether a compromise between the core and periphery is possible. Despite convergence criteria, some periphery countries joined the Euro with high debt and deficits.  The main problem with the Euro that signals that it might not work is that “European economies are too different” and “going in two opposite directions”.

For example, in 2001, the Eurozone’s main economies, France and Germany, slowed with increased unemployment while Ireland and Spain experienced a boom. These groups needed opposite solutions; however, the ECB lowered interest rates to help France and Germany prosper, which made Ireland and Spain suffer, contributing to a crisis in the periphery. Similarly, after the economic crisis, France and Germany are booming but Ireland, Greece, and Spain are in a recession, so the “core needs higher interest rates whereas the periphery needs lower interest rates”. Thus, the ECB has a choice to make between inflation in the core or unemployment in the periphery, but since the core has more power within the EU and the Eurozone, generally, monetary policy benefits the core and hurts the periphery.

Adjustment mechanisms such as labor movement, price and wage flexibility, and “interregional fiscal transfer payments” that work in the United States when only certain areas are under duress are less likely in the Eurozone due to linguistic and cultural barriers, limited labor market reform, and the political impossibility of core countries paying to support periphery countries. Without these mechanisms available to the Eurozone as they are to the United States, the euro-area will struggle with asymmetric shocks and divergent cycles among many other difficulties. The Euro will not work while the core and periphery have opposite economic conditions with no possible adjustment mechanisms and will further fiscal problems in the periphery because the Euro is “a one-size-fits-all policy for fundamentally different economies”. Despite economic changes, “the fundamental problems of forcing disparate countries to live with a single monetary policy and a single rate” persist.

 

Analysis and Conclusion

As a whole, the Euro has been an unsuccessful monetary union for many reasons, most importantly because of the lack of an optimum currency area and the divide between core and periphery economies. Despite the trade and job creation and greater European integration, the euro was mainly a politically motivated rather than an economic decision. However, despite the mistake of this monetary union, the euro is irreversible and will survive because of Germany’s economic influence, risk-averse voters, and potential further ECB powers.

One potential solution to the divergent economic problem is for the outliers to leave. Leaving the Euro could be disastrous for both the Euro and those countries that leave and thus is not a viable option. If the struggling countries formed a new currency union separate from the core countries’ currency union, there would be greater economic harmonization and more similar business cycles since the periphery and core separately would be closer to creating optimum currency areas. This solution would mean that the separate central banks would be able to help all countries in its optimum currency area by setting one monetary policy. Since the core and periphery states are on opposite boom-and-bust cycles, the ECB is unable to set monetary policy without hurting one set of countries. However, the periphery countries will not want to leave the euro because they desire to be part of a strong currency. If the periphery countries had their own currency, it would be weak even though the monetary policy would be better suited to those states’ economic situations. Additionally, the unplanned change of currency could lead to a market panic or loss of investor confidence, which could spark bank runs leading into another financial crisis. Thus, the breakup of the Euro is not a viable future option.

The EU must do something to improve the Euro situation, though. The EU plans to “improve the economic governance framework” of the EMU by improving and reinforcing the EMU. By the end of June 2017, the EU will complete the financial union, enhance democratic accountability, and increase competitiveness and convergence of structures. By 2025, the EU plans to increase convergence through legal means and to have established a treasury for the EMU. There is no correct solution to the Euro problem, and it is clear that the monetary union was a mistake. The Euro will not break up because it would create instability and potential crises. The EU’s plan going forward will not solve all of the Euro’s problems nor will it make up for the economic mistake it made by introducing the Euro, but it might bring the Euro closer to what politicians tried to start. The mistake of introducing the Euro is now an important part of the global economy and cannot easily be broken up without economic backlash, so it is important that EU institutions attempt to fix what they can to increase harmony in the EMU.

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