A Critical Review On The Effects Of The European Currency On Euro-area

Introduction

The concept of European integration was a direct result of the effects of the second world war, this process of political, industrial and social integration aimed to undo the barriers that were enforced during the war period between 1914-1945 (Wolf, 2008). This process was later aided by the launch of the European Monetary System in 1979, some researchers argue that this triggered the debate surrounding the Euro area being the Optimal Currency Area (OPA) as many nations in the European community fixed their exchange rate in relation to the current central parity known as European Currency Unit. The Optimal Currency Area theory, that will be analysed further, is the idea a geographical location that will produce high levels of economic benefit from the adoption of a single currency. However, authors from the institution of Economic Affairs (IEA) warned officials on the consequences of the convergence of currencies, the main argument opposing the introduction of the Euro was the concern that a single currency on a diverse economy will cause serious issues in a case of an economic shock. Despite the critics on January 1st, 1999 the Euro was introduced as the first single currency for the European nations participated in the exchange rate mechanism. These nations altered their domestic currency into a common European currency in aim to reduce trading costs by the removal of exchange rate risks and costs of hedging. Macdonald (2006) reported high inflation differentials between European Union (EU) member nations following the adoption of the Euro, however researchers such as Mongelli and Vega (2006) reports low levels of inflation and broad macroeconomic stability throughout these nations. This report aims to examine the effects of adoption of a single currency on the Euro-Area nations, by measuring the level of economic benefit reached and extent of Euro-Crisis’ to determine the extent in which the single currency implementation supports the Optimal Currency Area Theory. 

Literature Review

The formation of the European Union was subsequent to the signing of the treaty of Maastricht in 1993 resulting in the creation of the EU operating under 3-pillar like structure of governance. However, alongside the power of the European Economic Community (ECC) the EU did not possess any legal personality prior to the 2009 Lisbon Treaty. This treaty was an attempt at reform of the EU as it abolished the pillar structure and replaced the ECC resulting in a single body of governance. The reform of EU presented many trade benefits for member nations such as the trade creation through the removal of trade barriers and the elimination of exchange rate risk by maintaining a fixed rate between nations…add more effects of trade. However, Economists from the IEA expressed growing concern on the likelihood of bias on inflation rates arising from the use of single currency for several nations, as the European Central Bank will do anything in its power to rebut the chances of a recession in the Euro-area. Advocates for the adoption single European currency highlighted the elimination of currency fluctuations within the EU will promote gains, however macroeconomist Patrick Minford (2005) showed the any progress of currency fluctuation between Euro-Area countries can be nullified as they extent of fluctuation between the Euro and Dollar exceeds the fluctuation from the Sterling Pound and Dollar. However regardless this many practitioners such as Kohler (2004) state the lack of macroeconomic volatility in the Euro-Area in comparison to the U.S has contributed to the growing idea that Euro-Area is the Optimal Currency Area. Research conducted by Mongelli and Vega(2005) explores the OCA theory in-depth and examines the extent in which the Euro-Area matches the requirements. However due to the short time span between the introduction of the Euro and the findings of this research strong empirical assumptions cannot be made therefore reducing credibility. Despite this they concluded the low levels of labour mobility and migration between EU member states and the flexibility in price and wage levels directly oppose the OCA theory and need for single currency. The European Commission (2004) states the flexibility within price may be affected by the slow integration and dismantling of the trade barriers. Historical evidence reports that convergence of monetary unions that are not followed by political unions tend to fail, unification of fiscal rules tends to fail due to the heterogeneous characteristics of the EU member nations. However, the structure of the European Union consists of a centralized monetary system with a decentralized fiscal policy induces strong bias in the large fiscal deficits and contributes to the rising debt to GDP ratio in the Euro-Zone area. Following the introduction of the euro, the existence of a single currency for the eurozone has resulted in the nullification of any fiscal deficit from individual countries, this means there will be no rise in interest rate or change in exchange rate for the nation in which the deficit occurred. The lack of market feedback means large budget deficits cannot be disciplined, these cumulative deficits are detrimental to the value of the euro and the long-term real interest as these are responsive to the size of fiscal deficit and national debt within the eurozone. Large levels of cumulative deficit will apply pressure on European Central Bank to induce higher levels of inflation to erase the obligation of these deficits. 

Prior to the introduction of the Euro, a book ‘The Delors Report’ published by Delors (1989) played a significant role in the in the influence in the adoption of the single currency, this book suggested welfare improvement through the elimination of exchange rate risks within EU member states which is traditionally a point of conflict for the eurozone. The proposed reduction of exchange rate risks and decrease in interest rates influenced the Commission to decide the single currency would be suitable for growth in the Euro-area. Many researchers have taken different standpoints by measuring the different macroeconomic indicators to suggest a pattern of progression or regression, Fernandez (2015) suggests the adoption of the euro has caused a decline in the trend rate growth of GDP, in comparison to unemployment levels and inflation, as will be further dissected. The main concern of the single currency adoption was the cumulative risk and the lack of security from any economic shocks. In 1998 the previous leader of the British conservative party William Hague warned members of the EU that the adoption of the euro currency could amount to the equivalent to being in a burning building with no exits. This is analogy is prevalent in the recent economic and financial crisis of 2010, this was a direct result of the drastic increase in credit risk of government bonds due to the pressure EU to bailout failing European countries such as Greece, Ireland, Portugal, Spain and Cyprus, all with in a 2-year time period. Prior to the Euro-Crisis Spain had no significant fiscal problems and showed a surplus in their public surplus to GDP ratio, this further supports previous statements made by William Hague. The following section will consist of an analytical discussion on the effects of the single currency adoption on the euro area, to measure these effects the macroeconomic indicators will be analysed such as GDP growth rates, interest rates, inflation rates, debt ratios and money supply in order to determine the extent in which the eurozone can be classed as an Optimal Currency Area.

Discussion

Prior to the formation of the European Union, Germany suggested the addition of the limiting fiscal rule to the Maastricht treaty to limit the budget for fiscal deficit to GDP ratio to 3%, however by 2002, just three years after the introduction of the Euro both Germany and France exceeded this kick starting a disadvantaged system. Long term interest rates lack the ability to accurate reflect the differentials in budget deficit and the size of government debt within nations, this was apparent in the 10-year government bond rates reported in 2004, with almost identical rates shown between Italy, France, Spain and Germany. However, as previously mentioned low fiscal deficit and low debts ratios in Spain did not see rewards. This is portrayed through the lower levels of fiscal deficit are ignored by the line shown as the long-term interest rates. Appendix A shows the regression of the public deficit in relation to fiscal rule, this shows supports the hypothesis that monetary union is only successful if followed by fiscal union.

However, alongside the increasing public deficits and national bailouts researchers report rising concerns of growing levels of government expenditure towards unemployment benefits as a direct result of the euro-crisis. The growing debate on the suitability of the euro stems from its failure to generate high levels of growth. This resurfaces the debate on the classification of the European Union as an Optimal Currency area. In order to measure the effects of euro on euro-area and exclusively to Spain, these will by measured by the following macroeconomic indicators, GDP per capita, Inflation changes and employment rate. Research conducted by Fernandez (2015) shows the effect of the euro on a longitudinal time horizon as data over 20-year time period are considered, from 1990-2011. Figure 1 shows the effect of the introduction of the euro initial effects vary. The inflation rate has been decreasing on a linear basis, however the GDP per capita fluctuates. Upon the initial introduction of the euro there is spike in the GDP following the freedom of trade between the euro nations and the collective welfare benefits initially obtained.

The level of employment rate was an initial welfare gain that the euro brought, however was not did consolidated for in the long run, increasing the risk of European integration. The decline in employment rates between the employment rates between the years of period of 1999-2007 to 2008-2011 was a result of the financial and economic recession further emphasising the danger of monetary union. This results however deviate from the country in question, Spain. 

Upon comparing these two results, there are clear differences portrayed, prior to the introduction of the euro Spain yielded higher growth with levels of 4.70% this showed 3.2% higher than the average GDP of the euro area, Following the implementation of the euro the GDP decreased however still remained almost double of the average Euro-land figure. Finally, the final figure shows the effect of the 2010 euro-crisis had detrimental effects on the GDP of Spain and in fact impacted Spain more than average euroland. These negative affects lack of labour mobility support the theory that the euro-area is not suitable to be classed as an Optimal Currency therefore suggesting the divergence of currencies.

Conclusion

Many researches such as Mongelli and Vega (2006) argue the successful implementation of the euro currency through macroeconomic stability, this statement was correct to some extent as findings proved the reducing level of inflation as a result of the single currency. However, the euro has induced volatility in many other macroeconomic indicators such as budget deficits, interest rates and migration, therefore portraying a dissimilarity between the euro and growth. In order to combat the high levels of deficit in 2011 a multi-level fiscal agreement was imposed acting as a ‘automatic correction mechanism’ to ‘save the euro’. However, the direct of the impact of euro varies between nations as the union of several nations results in diversifying the risk between member nations, in this case Spain a nation that had high levels growth was subject to setbacks and experienced many obstacles in progression as a result of the euro, therefore suggesting crucial need for further reform.

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