A2 Economics

The Single European Currency

Key Issues
The essentials of Euro Area membership Convergence criteria Optimal currency area theory Recent macro performance of the Euro Area Single currency membership and external shocks The crisis for some Euro Area members

Basic history of the Euro Project

1991: Maastricht Treaty pathway for Euro 1999: Euro starts life as a currency y 1999-2001: Original members of system lock their currencies for two years 2002: Notes and coins come into circulation 2007: Slovenia becomes first of the new member states to enter the currency union 2008-09: Three new nations Slovakia, Cyprus and Malta the Euro Area extends to 16 nations 2009-10: Major stresses in the Euro as a fiscal crisis engulfs a number of member nations

The Euro Zone in 2006 12 Baffling Pigs

Belgium Austria France Finland Luxembourg Italy Netherlands Germany Portugal Ireland Greece Spain

The Euro Zone in 2010 16 Members

Belgium Austria France Finland Luxembourg Italy Netherlands Germany Portugal Ireland Greece Spain

Slovenia Slovakia Cyprus Malta

UK, Denmark and Sweden are all outside of the Euro

Euro Essentials
Monetary union is a deepening of economic integration between participating countries A single currency requires a common interest rate for the Euro Zone i.e. a common monetary policy Countries have locked their currencies together forever and adopted one currency as a medium of exchange Euro as a currency floats against US dollar and sterling e be at o s are also equ ed (in principle) eep Member nations a e a so required ( p c p e) to keep control of government borrowing i.e. They are not allowed to run large budget deficits > 3% of their GDP (in normal times)

Britain & the Euro The Current Position

Britain is outside of the Euro Zone It has an opt out from the single h t t f th i l currency

The European Central Bank (ECB)

ECB sets policy interest rates for the sixteen participating nations ECB objective is price stability defined as CPI inflation of 2% or below Countries joining the Euro must meet the convergence criteria

Convergence Criteria
Inflation: Average inflation over previous year must not exceed by more than1 5% that of the three lowest inflation than1.5% countries Government Finances Budget deficit must not exceed 3% of GDP Gross government debt must not exceed 60% of GDP Interest Rates: i ld t bonds t t d by A Average yield on govt b d must not exceed b more than 2% bond yields of three lowest inflation countries Exchange Rate Stability: Currency must have adhered to fluctuation margins of the ERM in two previous years without severe tension

Euro Area and UK Policy Interest Rates

Percent

A2 Economics

Optimal Currency Areas (OCA)

Is the Euro Zone an optimal currency area?

Is the Euro an Optimal Currency Zone?

An optimal currency zone occurs when:
(1) Countries have achieved real convergence (2) They respond in similar ways to external economic shocks or policy changes (3) They have sufficient flexibility in both their product markets and labour markets to deal with these shocks
High geographical mobility of labour High occupational mobility of labour g p y Wage and price flexibility in factor markets

(4) Countries are prepared to use fiscal transfers to even out some of the regional economic imbalances within the European currency union

Optimal Currency Zones (2)

The Euro Zone is not an optimal currency zone! The core group of EU countries are broadly similar (Germany + France + Netherlands) Peripheral countries have big structural differences e.g. Ireland, Greece, Portugal and Spain Response to interest rate changes varies across countries And there are barriers to the mobility of labour The Euro Area is a diverse group of countries and this k i fit ll t li hugely diffi lt l difficult makes a one-size-fits-all monetary policy h Less of a problem during benign economic conditions of the late 1990s and first half of the last decade But recent economic and financial turmoil has exposed weaknesses in the currency union

Optimal Currency Zones

Highly Flexible

Monetary Union Works

Labour Market Flexibility

High risk currency union Inflexible

Divergent

Real Economic Convergence

Convergent

A2 Economics

The Case for Entry into the Euro

Microeconomic Benefits of Entry (1) Potential Gains for consumers Gains from price transparency Reduction in the transactions costs of travelling within Europe (e.g. costs of currency exchange) Cheaper mortgages if interest rates are lower

Microeconomic Benefits of UK Entry (2) Possible gains for businesses Invoicing with just one currency Lower transactions costs when trading Stable currency and low inflation might allow businesses to fund their capital investment at lower real interest rates

A2 Economics

The Case for Staying Outside y g

Microeconomic Disadvantages
(1) Changeover Costs from joining the Euro: Menu Costs (vending machines, catalogues, franking f ki machines, postage hi t Customer confusion (imperfect information) (2) Higher prices
Potential loss of consumer welfare if suppliers increase prices when converting from sterling to euro

(3) Lost instruments of policy adjustment ( ) p y j

Problems of a one-size fits all policy rate Retaining the option of making an exchange rate adjustment is useful

Recent performance of the Euro Area

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Comparing growth rates UK & Euro Area

Germany - the largest country with the Euro - a driver of policy decisions?

Percent

Percent

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Convergent Economic Cycles?

Low real interest rates stimulated an unsustainable boom in some countries

2000=100

12

Ireland boomed but over-heated

A similar story in Spain now unemployment soars as recession bites

Percent

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One currency but different inflation rates

And diverging unit labour costs which affects competitiveness in Euro Area

Index

1996=100

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UK and Euro Area Inflation Compared

Percent

What about unemployment rates?

Per cent of the labour force

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Unemployment in Spain and Ireland

Percent

Some EU states are not ready to join the Euro E.g. interest rates still Poles apart

Percent

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Some countries have pegged their currency to the Euro

Fiscal Crisis: A Growing Debt Problem

PERCENT

EUR/LVL

EUR/EEK

17

The Euro floats against the US Dollar

And against UK sterling

EUR/GBP

USD/EUR

18

Challenges facing the Euro Zone

Stresses and challenges facing Euro Area

1. Little common fiscal policy
Big differences in size of fiscal deficits and debt levels Fiscal stability pact has effectively collapsed Growing risk of one or more Euro Area countries defaulting on some of their debts Will Euro Area nations bail out fellow members? Years of fiscal austerity for some nations will create deep economic and social pressures

2. Doubts about the likely strength of recovery

Unemployment high and rising Rising cost-push inflation could lead to higher interest rates and choke off confidence as recovery starts

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Longer-term challenges
Growth and employment creation in the Euro Area has not been noticeably higher than in countries outside o tside the c rrenc union currency nion 2008-10 crisis has highlighted the problems of setting a common interest rate for 16 nations Larger economic imbalances within the 16 nation currency union over wage levels, trade balances and productivity will a so need to be add essed if also eed o addressed a d p oduc y the Euro Zone is to avoid future crises Several weaker countries have become uncompetitive inside the Euro and this requires painful corrective policies which will be unpopular

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