SWITZERLAND AND MEMBERSHIP IN THE EUROPEAN MONETARY UNION

Considerations for Swiss Policy Makers Regarding Membership in the European Monetary Union Nathan Cornett Eastern Michigan University

SWITZERLAND AND MEMBERSHIP IN THE EUROPEAN MONETARY UNION

Abstract This paper explores the implications and policy considerations associated with the question as to whether or not Switzerland should forego their national currency (Swiss Franc) and pursue membership in European Monetary Union. Collectively analyzing existing research relating to this topic, this paper describes the many factors that need to be considered when attempting to answer this question including the currency unions possible effects on trade and exchange rates, potential impact on the Swiss Francs role as a global safe haven currency, and also effects on seigiorage and government financing. Additional research questions are also mentioned as important areas of study that need greater analysis to help aid Swiss policy makers in deciding whether or not to join the European Monetary Union. Keywords: Switzerland, European Monetary Union, currency unions

SWITZERLAND AND MEMBERSHIP IN THE EUROPEAN MONETARY UNION

Consideration for Swiss Policy Makers Regarding Membership in the European Monetary Union

Complexities involving international trade including barriers such as taxes, exchange rates, and different product regulations have long been seen as inefficiencies in the global market place. It is the recognition of such restrictions that has called for more open markets and limiting these trade barriers. Diverse and powerful economies such as the one found in Switzerland have lots to gain from diminishing trade restrictions. Switzerland, a country of only 7,639,961 boasts a GDP of over 320 billion accounting for a GDP per capita which ranks them 12th in the world (Central Intelligence Agency, 2011). The Swiss are primarily a service economy; however industries also help contribute to their vast export revenues including machinery, chemicals, watches, and textiles equating to 230 billion dollars (Central Intelligence Agency, 2011). Industrial modern economies such as Switzerland have much to gain in terms of trade, and it has only been in the last few decades that policies have been implemented to limit trade barriers. Many policies have been developed and implemented throughout the world in order to increase commerce between nations including trade organizations and currency agreements, all with varying degrees of commitments from member states. In Europe, organizations such as the European Union act as forums to discuss trade and different economic matters. On January 1, 1999 a major initiative to promote trade was realized when the European Monetary Union enacted the Euro form of currency (though not in physical form at the time). The goals expressed by the EMU in which they believed the adoption of the Euro would help them achieve included greater choice and stable prices for consumers, greater security and more opportunities for businesses, improved economic stability, and more integrated financial markets (European

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Commission: Economic and Financial Affairs, 2011). In many ways the European Union, EMU, and the Euro have all been extremely successful in these endeavors. Danny Mcgowan of the University of Nottingham attributes a 6-11% increase in trade resulting from the EMU currency union (Mcgowan, 2008). Figures vary as to the precise amount of growth attributed directly to the adoption of the Euro; however there seems to exist a certain school of thought that states countries who share a common currency may trade up to three times as much as they would with different currencies, and from this increase in trade comes economic growth (Rose, 2001). Just as this school of thought was beginning to make headway as an effective tool for economic growth, recent economic events and various political rational suggest that adoption of a single common currency may prove to be detrimental to economic growth. Increased sensitivity to foreign debt among the EMU members shows volatility in new monetary union movement. This scenario has manifested itself in Europe as the countries of Germany and France struggle support countries with weaker economies such as Greece while attempting to control the massive amount of Greek public debt. Current events show the importance of understanding these issues and why more analysis needs to be done regarding the two different beliefs. Interestingly enough, Switzerland has chosen not to become an official member of the European Union or EMU, and still employs its local Franc currency. Membership in the European Union does not necessarily require membership in the EMU; however there does exist trade agreements involving European Union members that could potentially benefit Switzerland separate from joining the European Monetary Union. To the outside observer it may seem odd seeing as Switzerland is surrounded by European Union Countries, and 3 of its top four trading partners (Germany, Italy, and France) are all European Union and EMU members (Central Intelligence Agency, 2011). It is this fact among others that makes Switzerland a particularly interesting case

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study with regards to the EMU in particular. Why would this modern industrial nation choose not to partake in the growth that their neighboring states have enjoyed as a result of involvement in the EMU? How has this impacted Swiss industry, and are the Swiss actually benefitting from not being in the EU or EMU? It is these questions that this paper will answer, and possibly provide counter-arguments against the movement to form more currency unions Literature Review Switzerlands decision to remain independent from its European trading partners as it pertains to the European Monetary Union has been explored by researchers in considerable depth. It is characterized in the literature that ascending countries in particular aim to be full members of the EMU (Levasseur, 2004); however an economically powerful Switzerland may benefit from remaining independent. A great majority of the research has centered on trade and exchange rates but there has also been research conducted in areas of public finance and different political aspects. Many of the scholastic research articles below highlight these arguments as well as some a few less publicized aspects of a potential currency union. Simply put, the decision to enter a monetary union can be described as a tradeoff between macroeconomic flexibility against microeconomic efficiency (Krugman, 1992). However measuring these tradeoffs is no simple task as the literature points out. Torsten Persson(2001) references this dilemma in his critique of Andrew Roses findings (Rose, 2001) stating that, accurately measuring the effects on trade of currency unions can be quite difficult as the determinants of trade become increasingly complex. Those who are proponents of currency unions often express the trade benefits associated with these unions. These people often cite the findings of Roses One Money One Market in which he suggests that currency unions can

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increase trade 300%, as well as have positive impacts on price stability and more trade convergence (Rose, 2001). The authors of The Currency Union Effect on Trade: Early Evidence from EMU critique Roses findings, suggesting that the impact is not quite as significant, and expand their research to include trade between members of the currency union and nonmembers. In the Currency Union Effect on Trade, the authors research suggests that the data from 1999 to 2002 shows an impact on bilateral trade from the European Monetary Union to be around 4-16% depending on the two particular countries (Micco,etal.2003). Interestingly enough, the data does not show any signs of diversionist practices among the EMU members suggesting that the creation of the EMU has benefited all parties and not just the members of the currency union (Micco,etal.2003). This observation could be of particular interest to Swiss policy makers when deciding whether or not to eventually enter into the currency union because it may diminish the vast tradeoff that is perceived to exist when a country chooses to join a currency union. If Switzerland is able to benefit from the currency union without surrendering their exclusive economic control i.e. monetary policy, then microeconomic efficiency could be maintained while also sharing in the macroeconomic benefits from the increased trade due to the currency union their neighbors operate. There does exist a disproportionate impact level however, where intra Euroland trade between 2 EMU members was measured at 34% and trade between 1 EMU member and nonmember was calculated at 15% between the 1993-2002 (Micco, etal.2003). Understanding the complexities of the factors that need to be taken into account in order to decide whether or not to commit to a currency union, Micco, etal. offer some benefits and weaknesses of a single currency. First the authors reference the claims in that suggest a single currency eliminates bilateral nominal exchange rate volatility, which in turn should reduce the risks and uncertainty

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involved in trade transactions (Rose, 2001). Costs associated with a multi-currency system stem from more than just risk, but also from the seemingly practical cost from exchanging currencies (De Grauwe, 1994). De Grauwes research points out that in 1992 estimate costs from exchanging currencies for trade was .5% of GDP for the European Union as a whole, and this cost for smaller more open countries could amount to 1% of GDP (De Grauwe, 1994). Discussions as to optimal currency areas as it pertains to population size often come up in debates. It can be noted that economies in countries such as Iceland, Liechtenstein, San Marino, and Monaco in which their populations are so small and economies so dependent on trade with neighbors that it would be economically inefficient to have their own currency (Goodhart, 1995). Switzerland may seem to fall in this same category of being too small to effectively benefit from its own currency; however despite Switzerlands relatively small geographic boundaries and population, the countries diverse service based economy, highly skilled work force, and a selfsufficient manufacturing sector have contributed to a GDP of 340.5 billion dollars in 2011, ranking them 38th in the world (Central Intelligence Agency, 2011). Part of the difficulty in the decision of whether or not to join the EMU for Swiss policy makers will be to determine if their size has been hindering them from possibly increasing GDP, or whether Switzerland is large enough on its own for it to be economically viable to continue with the Swiss franc. For many years, the Swiss Franc been recognized as a safe haven currency for investors looking to hedge their risk in the global money market. In a report issued by BFI Consulting AG, the Swiss Franc is studied as to whether or not its role as a safe haven currency will continue with the adoption of the Euro. It is important for potential Swiss policy makers to realize the costs and benefits of adopting the Euro as it pertains to their current role as a worldwide safe haven (Suess, 1999). Suess states the proponents of the EU argue that a potentially weak Euro

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could drive up the value of the franc greatly hurting Swiss exports. There also exists the argument according to Suess that the franc could potentially become a clone of the Euro and as such diminish its significance and role as a world currency. Neither of these scenarios has occurred according to the author, and he credits the Swiss National Bank (SNB) for playing a large role in this outcome. Initially targeting exchange rates when the Euro was adopted, the SNB focused its monetary policy on remaining relatively close to the Euro limiting currency volatility (Suess, 1999). Later as exchange rates fluctuated between the Euro and Dollar, the SNB shifted its policy towards price control preparing for the resulting currency market adjustments (Suess, 1999). It is this ability of the SNB to efficiently react to the changing global economy that will allow it to be a safe-haven currency despite the adoption of the Euro for the foreseeable future (Suess, 1999). A less publicized and often overlooked aspect of currency changes how seigniorage will be affected in a countries national banking system, and whether or not gains or losses will be had by a change in currency. Seigniorage denotes the revenue stemming from the monopolistic right to issue central bank money, i.e., currency and bank reserves (Fischer, Jordan, & Lack, 2002). Fischer Jordan and Lack explore this aspect of changing currencies through their research and conclude that overall the loss of potential revenue generated from seigniorage should not be the determining factor on whether or not Switzerland should join the European Monetary Union; however it is a factor that should not be ignored. Revenue generated by the Swiss National Bank through this financial instrument is either held in foreign currency reserves or redistributed for government financing (Fischer, Jordan, & Lack, 2002). As of 1999 2% of cantonal or local government and .8% of federal government revenue is generated through this means (in terms of Euro) (Fischer, Jordan, & Lack, 2002).

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What the bulk of these authors research examines is the potential real losses that could incur to government revenue if a move to the euro where to take place. Based on 2002 EMUs derivation of member countries capital share which is the determining factor on their seigniorage distribution, Switzerland stands to suffer a loss in revenue. Characteristics of the Swiss economy including currency holdings and circulation negatively affect their ability to receive proportionately fair revenue given the 2002 EMU policy (Fischer, Jordan, & Lack, 2002). According to the authors calculations, Switzerland looks to lose as estimated 13 billion Euros in seigniorage generating revenue that would result in a seigiorage loss from 313 million euros to 700 million given the interest rate at the time of entry into the union (Fischer, Jordan, & Lack, 2002). Aside from the obvious financial losses from this hypothetical move to the European Monetary Union, the authors suggest that division between the cantonal government and the national government as a result of the disproportionate revenue loss, and that the federal government will have more direct control over the funds they receive from the EMU (Fischer, Jordan, & Lack, 2002). Political literature has also touched on the potential impact of currency unions. Benjamin Cohen (2000) describes the magical virtues of money which includes the sense of national identity which is enhanced through a state currency and suggests that currency underscores the fact that everyone is part of the same social entity. For any country considering joining a currency union, this idea of a nations currency being tied to a national identity is certainly something to consider when deciding whether or not to join/form a currency union. Politically speaking, politicians who may want to be perceived as progressive and open to the world by their constituents may consider the currency union. On the other side, a politician may want to show

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how patriotic he/she is and as such may choose to continue with the countries original currency. Depending on who is making the decision and whether or not a political backlash may occur from a currency switch, the policy makers will have to undoubtedly consider the political ramifications from their decision. A great deal of the literature regarding the effects of monetary unions and in particular the European Monetary Union focuses on the effects on trade and interest rates. There is good reason for this seeing as these two factors are often at the center of the argument to create a union In The Economics of Monetary Unions, Paul de Grauwe (1994) outlines in great detail how exchange rate uncertainty relates to the benefits of monetary unions as well as how the single currency notion relates to trade openness. Limited research however has examined the direct effect the union has had as it pertains to fiscal and monetary policy; mainly if inefficiencies have resulted due to the collective nature of the monetary unions under one central bank. There is also limited literature about the possible effects the EMU has had on the often criticized Swiss banking system. This is most likely attributable to the secretive nature of Swiss banking, nevertheless it would be interesting to see if deposits have increased as a result of European Union banking regulations. In light of the current economic events surrounding Greece and the Euro, it would be interesting to see the effect of their economic woes on EMU members and whether or not Switzerland will be affected as great. All these questions could factor into a Swiss policy makers decision as whether or not to enter into the EMU. Conclusion With regards to the question of why Switzerland has elected to retain its own currency and in all other monetary aspects remain separate from the EMU, the current literature presents

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many reasons. Understandably much of the research is centered around the impacts on trade and exchange rates. As expressed in How Large is the Treatment Effect by Torsten Persson, measuring the impacts of currency unions on trade proves to be an extremely difficult task. Authors Micco, etal. add to the ideas express by Torsten (2001) highlighting the fact that their findings on the impact of currency unions on trade differ from the controversial findings from Rose suggesting that currency unions can potentially increase trade 300% (Micco, Stein, Ordoez, Helene, & Viaen, 2003). Inconclusive results on the perceived gains from currency union formation may add to the uncertainty and perceived risk of entering into such a union. Further research could be done to quantify this risk and describe its overall role in Switzerlands decision making process as whether or not to join the EMU. As it relates to exchange rates and the Swiss francs role as an international safe haven currency, Suess credits the Swiss National Bank and their monetary sovereignty from preventing the franc from becoming a clone of the Euro or becoming priced too high as a result of Euro dumping (Suess, 1999). A potential research question stemming from the existence of the SNB is the possible loss in monetary policy efficiency from switching to a more collective national banking system such as the European National Bank. Limited research has been done in this area, and understanding the possible losses or gains due to the collective nature of the ECB could help Swiss policy makers in their decision as whether or not to remain separate from the EMU. Analyzing the impact of the potential adoption of the Euro from an internal perspective, authors such as Fischer, Jordan, & Lack conclude that Switzerland could lose between 313 million euros to 700 million euros from lost revenue due to a decrease in seigniorage base of 13 billion euros if they joined in 2010 (depending upon current interest rates) (Fischer, Jordan, & Lack, 2002). Stating that this loss in seigniorage should not be a determining factor in Switzerlands decision to

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remain independent, Fischer, Jordan, and Lack do conclude that it should be a factor in the equation. Overall the research does not conclude that Switzerland should or should not join the EU. Relatively limited data due to the newness of the EU and currency unions have led to great disparity in potential gains from these unions, and further research questions need to be explored before definite conclusions can be made. This point is iterated in Miccos, Steins, Ordoezs, Helenes, and Viaens critique on Roses findings stating that assumptions such as linear relationships and random sampling errors may contribute to inaccurate findings (Micco, Stein, Ordoez, Helene, & Viaen, 2003). These indefinite conclusions and weaknesses in the research call for more research questions to be explored in order to truly understand the impact of currency unions, and specifically whether or not Switzerland should join the EMU. Such possible research questions could include the Euros impact on specific industries i.e. do currency unions favor economies with heavy manufacturing bases vs. service oriented economies? Also would forgoing financial sovereignty (which is often associated with belonging to organizations such as the EMU) with regards to regulations hurt the Swiss economy; specifically the possibility of increased banking regulations? These questions among others all need to be explored and analyzed effectively by policy makers to determine the proper course of action as it pertains to Switzerland joining the European Monetary Union.

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Works Cited Cohen, B. J. (2000). Monetary Union: The Political Dimension. Santa Barbara: University of California at Santa Barbara. De Grauwe, P. (1994). The Economics of Monetary Integration. Oxford: Oxford University Press. Fischer, A. M., Jordan, T., & Lack, C. P. (2002). Giving Up the Swiss Franc: Some Considerations on Seigniorage Flows under EMU. Swiss Journal of Economics and Statistics, 61-82. Goodhart, C. (1995). The Political Economy of Monetary Union. In P. B. Kenen, The Macroeconomics of the Open Economy. Princeton: Princeton University Press. Krugman, P. R. (1992). What Do We Need to Know about the International Monetary System? Princeton: Princeton: International Finance Section. Levasseur, S. (2004, May). Why Not Euroisation. Revue de l'OFCE, pp. 121-156. Micco, A., Stein, E., Ordoez, G., H. K., & Viaen, J.-M. (2003, October). The Currency Union Effect on Trade: Early Evidence from EMU. Economic Policy, pp. 315-356. Persson, T. (2001, October). Currency Unions and Trade: How Large is the Treatment Effect? Economic Policy, pp. 433-488. Rose, A. K. (2001, December 25). One money, one market: the effect of common currencies on trade. Economic Policy, pp. 7-46. Central Intelligence Agency. (2011, October). The World Factbook. Retrieved October 5, 2011, from cia.gov: https://www.cia.gov/library/publications/the-world-factbook/geos/sz.html European Commission: Economic and Financial Affairs. (2011, January 14). Why the Euro? Retrieved October 5, 2011, from European Commission: http://ec.europa.eu/economy_finance/euro/why/index_en.htm Mcgowan, D. (n.d.). Has the Euro Increased Trade? Leverhulme Centre for Research in Globalization and Economic Policy.