Accomplishments and Challenges of the Euro-Zone - dummies

Accomplishments and Challenges of the Euro-Zone

By Ayse Evrensel

Since its introduction in 1999, the euro has accomplished many positive milestones: The most obvious benefit of adopting a single currency is to remove the transaction cost of exchanging currency. Consumers and firms pay no fees for cross-border transactions. Inside the Euro-zone, all monetary transactions use the same currency even if a transaction is across national borders.

The risk of unanticipated exchange rate movements always adds uncertainty for individuals or firms when investing or trading outside their own currency. But the common European currency removes all exchange rate risk within the common currency area. All transfers within the Euro-zone are treated as domestic transactions and there is no exchange rate risk. Companies that hedged against exchange rate risk no longer need to consider this additional cost.

This factor is particularly important for countries whose currencies fluctuated a great deal, such as some of the Southern European countries.

  • Studies suggest that the introduction of the euro increased trade within the Euro-zone by 5 to 10 percent.

  • The absence of exchange rate risk and restrictions to capital transfers within the Euro-zone seems to have increased investment in physical capital within the Euro-zone by 5 percent since the introduction of the euro. Studies also suggest a large increase of 20 percent in foreign direct investment within the Euro-zone. Additionally, the euro increased investment in countries with previously weaker currencies by an average 22 percent.

  • A common currency promotes the integration of financial markets in the common currency area, which increases the liquidity of financial markets. Increased liquidity and lower transaction costs may help financial firms in the common currency area compete better within and outside the common currency area.

    In fact, strong evidence indicates that the introduction of the euro has greatly contributed to European financial integration. The euro has decreased the cost of trading in bonds, equity, and bank assets within the Euro-zone.

  • Differences in prices motivate arbitrage; therefore, commodities are traded just to exploit price differentials. But a common currency is expected to decrease differences in prices. The evidence on the convergence of prices in the Euro-zone is mixed.

    Some studies cannot find any evidence of price convergence since the introduction of the euro, but they find evidence that ERM I had largely achieved convergence by the early 1990s. Other studies find evidence of price convergence following the introduction of the euro in a sector-specific way. The evidence points to the automobile sector as an area of strong price convergence.

Some economists argue that the euro-zone isn’t an Optimum Currency Area (OCA) and provide the following explanations:

  • By the time the euro was introduced in 1999, the intra-EU trade made up 10 to 20 percent of the EU members’ output. Since the euro, the intra-EU trade makes up about 16 percent of the Euro-zone’s GDP. The euro’s contribution to the increase in intra-EU trade is suggested to be about 9 percent, which isn’t a substantial reason to have a single currency.

  • Despite the laws regarding the free movement of labor within the EU, labor mobility has remained at a minimum, possibly due to cultural, linguistic, and other legal barriers.

    Although labor is allowed to move freely within the EU, because a high percentage of the European labor is unionized, labor laws and regulations related to benefits still discourage mobility within the EU Strong union presence, as well as generous and longer unemployment benefits in Europe, have contributed to persistently high unemployment rates. Some economists recommend introducing supranational employment policies to make labor more mobile in the Euro-zone.

  • European economies are diverse and experience asymmetric economic shocks. The economies of Germany and France have not much in common with the economies of the smaller Baltic or Balkan countries, or some of the Mediterranean countries. For example, whereas Greece runs large current account deficits, Germany usually has current account surpluses. Greece and Spain have larger public debt than other countries in the Euro-zone.

  • Diverging economies may be more problematic than dissimilar economies for a common currency area. The ECB is committed to lower inflation rates and a strong euro. However, lower inflation and a strong euro may be costly for the export sectors of some of the weaker Euro-zone countries. Therefore, current differences may lead to divergence among economic performance in Euro-zone countries.

  • The ECB’s commitment to price stability takes monetary policy out of the list of possible remedies for countries with weaker economies and higher unemployment rates. Additionally, fiscal policy is a problematic issue in the EU in general and the Euro-zone, in particular.

    In terms of fiscal policy, most EU countries have been skeptical toward a supranational fiscal authority. Therefore, fiscal policy remains as the individual Euro-zone country’s affair. The EU budget is too small to transfer resources into slow-growth areas.

  • One predictable consequence of adopting the euro is the decline in interest rates. This factor increases the market value of firms, especially in countries with weaker economies and currencies. Before the sovereign debt crisis in the Euro-zone, the cost of borrowing fell significantly in Greece, Ireland, Portugal, and Spain.

    Although the convergence criteria could prevent a prospective EU member with large government deficits from entering the ERM II or the Euro-zone, after a country is in the Euro-zone, the EU’s control over the country’s fiscal affairs may weaken. Consequently, countries may be in the position of accumulating substantial public debt.