Introduction of the Euro - dummies

By Ayse Evrensel

The euro was introduced as an accounting unit in 1999 and as currency in circulation in 2002. But the emergence of the common currency was based on almost half a century of discussions and preparations.

A very brief history of the European Union

In 1946, following the end of World War II, British Prime Minister Sir Winston Churchill gave a famous and momentous speech at the University of Zurich. He talked about Europe as a continent of great wealth and distinct cultural heritage. But he called the devastating conflicts and wars on this continent as the tragedy of Europe.

Churchill’s proposal recognized the common historical and cultural inheritance among the European people and called for the creation of a European family. This famous speech introduced the phrase “the United States of Europe.”

The first attempt at European integration started with the European Coal and Steel Community (ECSC), introduced by the Paris Treaty (1951). Because coal and steel had been crucial for European countries’ war industry, the aim was to introduce a supranational authority that would oversee the peaceful use of these strategic resources. Six countries (France, West Germany, Italy, Belgium, the Netherlands, and Luxembourg) signed the Paris Treaty.

In 1957, the same six countries signed the Rome Treaty, which introduced the European Economic Community (EEC). Even though the EEC started as a customs union among these countries, it became instrumental for the subsequent economic and monetary unification of Europe.

Between the establishment of the EEC and the Maastricht Treaty in 1992, the economic and political integration of Europe continued in the areas of defense, the judicial system, and foreign policy. By the time the Maastricht Treaty was signed in 1992, European integration was much more than just an economic cooperation. This treaty thus renamed the EEC as the European Union (EU).

Most important, the Maastricht Treaty formally introduced the idea of a single European currency, which became the euro. The first step toward a common currency was the European Currency Unit (ECU), an accounting unit consisting of a basket of a specified amount of member countries’ currencies.

Optimum currency area (OCA)

An important question for the euro was whether there was a good economic reason to have a single money for the EU. In economics, this question is answered in terms of whether an area is an “optimal currency area.” An optimum currency area (OCA) refers to a geographical region consisting of a number of countries in which the use of a single currency increases economic efficiency.

The theory of the OCA became important in the 1950 and 1960s when the fixed exchange rate regime of the Bretton Woods system was thought to create balance of payments crises. At that time, as some economists were calling for flexible exchange rates, others were searching for other exchange rate systems. The OCA was an example of the latter.

Additionally, the EEC was introduced in the late 1950s as a custom union to encourage free trade among the member countries. Whether member countries should have flexible or fixed exchange rates within the EEC and whether they should share a single currency were important questions at that time.

The OCA argument doesn’t deny the efficiency of using a common currency in an area (region) previously consisting of nations with their distinct currencies. However, the term optimum in optimum currency area suggests that a common currency isn’t suitable for every region. An OCA should have the following characteristics:

  • Countries in the region should have a similar economic structure and, therefore, be affected by similar economic shocks. For example, if all countries in the region produce textiles and wheat, a productivity shock to the textile industry would affect all countries in the region. The region then is a good candidate for an OCA.

  • The region should have labor mobility. If free movement of labor is restricted, unemployment rates would persist in some countries. Additionally, national stabilization policies cannot address economic shocks to all sectors. In this case, labor mobility may help decrease the unemployment rate.

With these characteristics present, a common currency requires coordinating monetary policy among the countries in the region and, therefore, establishing a common central bank. In an OCA, nation-based monetary policies weaken the credibility of a common currency. In addition, symmetric economic shocks are helpful so that the common currency’s central bank can implement stabilization policies that affect the entire area or region.

After fulfilling the requirements of symmetric shocks and labor mobility, the efficiency-enhancing effects of a common currency take place in the flows of goods, services, and capital within the area. For example, as the use of a common currency increases trade among the common-currency countries, increased trade lead to price convergence within the common currency area.