Mark Xenakis International Accounting Fundamental Macroeconomic Flaws in the Euro Five years ago, the biggest thing in economic and international news was the introduction of the new European currency, the Euro, into circulation and into the pockets of the consumers of the participating countries within the European Monetary Union. In an attempt to unite Europe and to form a dominant currency to rival the US dollar, Europe locked their exchange rates and went full steam with this plan. Unfortunately, for many of the European countries, what seemed to be the end all for European economics, quickly unraveled the inherent reality of the fundamental macroeconomic flaws in the European monetary system that may cause its downfall and deficit policy that could lead to its utter collapse. Even with this in mind, some speculate that, with the right amount of revision and monitoring, the Euro might actually have a chance of becoming the worlds leading currency. In any cases, however, before looking this far into the future, we must first remember the past. For decades, Europe and all of the countries within its continental borders have disagreed, argued, and on many occasions, fought wars over disputing issues, differing cultures, and the occasional expansionist fascist.
From WWII, to the Russian uprising, Europe has been separated by years of wars and hatred. And despite attempts, it is this reason, among many, which has hindered the coming together and agreeing upon many common goals needed for Europe to grow and thrive as an economic contender. Since these post war years, Europe has seen many steps taken to unify Europe. We have seen the formation of the European Union which has been a crucial step and huge driving force in the thought process behind the Euro itself and many more pieces of legislation and plans for future European monetary policy. "One of the unique characteristics of Europe that make it different from any other region in the world is the extreme political fragmentation that has existed and the diversity of its population.
People that travel Europe can be amazed by the fact that every few hours they can enter into a new country with a different language and culture." (Soto) Despite these differences, the European Union came together in the 1970's to adopt two plans that would ultimately alter the monetary face of Europe as we know it-the Warner plan and the subsequent proposal statement on the prospects of a monetary union (EMS). These were said by many to be two of the most important and ambitious plans proposed and passed by the EU." It [Warren plan] stressed the need to move forward simultaneously in coordinating policy, and in narrowing exchange rate margins, the integration of capital markets and the establishment of a common currency and a single central bank" (Urwin) Even though this movement was so ahead of it's time, it created the vision of a united Europe and set the foundation for other EU developments toward European integration. The EMS was not as ambitious or as idealistic as the previous warren plan was, but rather it was more of a realistic set plan that laid out how to go about the long road toward integration. The EU moved closer and closer throughout the 1980's and the 1990's as many more agreements and treaties were introduced and signed. Finally, five decades after the end of the WWII, Europe was in the final stage of essentially accomplishing the "." On January 1, 1999 the European Union and its 11 pioneering nations composed of Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, The Netherlands, Portugal, and Spain accepted the Euro as their new currency. There is no doubt that the major players within the European Union had good intentions and brilliant, idealistic, plans for the Euro and for the uniting of Europe.
The Euro was not just thrown together in a day, it has been worked on since the 70's and to say it was poorly thought out wouldn't really fit the bill. The Euro does have many underlying benefits but as the saying goes, there is no such thing as a free lunch. Currently standing at $0. 78, the value of the Euro is a far cry from its $1. 17 introduction in 1999.
Obviously its benefits don't come without its costs, and as I will make clear in these next paragraphs, the Euro has enough problems to go around. (Soto) Theoretically, there two basic requirements for a monetary Union to succeed; There should be an optimal currency area, and there must be a convergence of the economies of the participating countries. Krugman and Obs fel define an optimal currency area as "groups or regions with economies closely linked by trade in goods and services and by factor mobility." (1994) If the conditions to the OCA are met, the area involved will theoretically benefit from the fixed exchange rate system as proposed by the Euro. And likewise, if Europe did not constitute an OCA, the costs to the Monetary Union would exceed the benefits from it. So the obvious question then becomes-Is the Euro zone an OCA? Lars Jon ung, from the Stockholm School of Economics don't think so:" Europe is not an optimal currency area-that is, a geographic area well suited to have only one currency. There is no common currency cycle, at least not yet." (Soto) Martin Feldstein of Econ Log explains why Europe is not an optimum currency area, even though the United States is one." First, American employees move within the country when demand is relatively weak in a particular region, facilitated by a common language and culture that regards moving across the country as perfectly normal.
Germans are not leaving Germany in large numbers for areas of Europe with faster growth or lower Unemployment. Second, wages are much more flexible in the US than in Europe, reducing the decline in regional employment that occurs when demand falls. And third, the US has a federal fiscal system that directly offsets about 40 percent of the relative decline in any state's gross domestic product by a lower outflow of taxes to Washington and a higher inflow of transfer payments. European fiscal systems are still largely national." (Feldstien) One of the most important characteristics that differentiate The European Union from US is the Labor market. In the US, companies have almost no cost for labor except the obvious payroll and finding a qualified, skilled person to fit the position.
US companies can also adjust their profits modifying their payrolls. People can easily go from one side of the country and have no problem finding a job on the other. (Soto) The situation in Europe is quite different. With factors such as the language differences, cultural differences, and the slow growth of most of Europe, this situation is not likely to change any time soon. In addition to this, The actual labor mobility is low, much lower in fact than US or Japan. (JP Morgan) Another hurdle European companies must face in the near future is labor market flexibility.
The concept of flexibility in this case indicates how fast an adjustment can be made within the labor markets." If in a recession, workers are willing to accept lower wages, employer will only be able to maintain the same number of employees, but also to pass on the reduction in payroll costs in the form of lower prices. Lower prices, in turn, spur exports and lead domestic consumers to buy fewer imports and more locally made goods. That increase in demand spurs economic recovery." (Soto) The second requirement for the success of the Euro monetary system is convergence. In an effort to standardize, in some way, the economical goals in the countries of the Euro zone, convergence is needed, this means that economies qualifying for the Euro must be in similar condition of fitness. Convergence is one of the fundamental aspects of the European Monetary Union. It establishes what a country needs to enter into the European Union and the certain things it must do in order to remain in the Euro-zone.
People tend to forget, however, that even if the current economical standards are met in a certain country, it is possible that some business cycles of these countries wont be correlated at all with neighboring countries or with the central bank. There are only a few countries, in fact, that share similar cyclical developments with their neighboring countries. This again points out a weakness in the system because the cost to adjust for cyclical convergence in low income countries will increase with the union. (Soto) When these 11 countries enter into an agreement like the Euro Zone, they were also agreeing to the elimination of their own monetary policy. This can have severe implications on the country's ability to respond quickly domestic economic problems. When a country joins an union such as the Euro Zone, it essentially gave up there interdependent monetary policy.
The problem with this, is that monetary policy will keep working at the regional level, however, surrounding countries, with a completely different monetary policy will pressure the regional county to apply their own policy. The consequences of an interdependent monetary policy can be inferred from Eu dey when he explains what would happen if a recession hits one country:" Currently, its central bank may respond to the recession by increasing money supply, thereby pushing interest rates downward... The Central Bank for the European Monetary Union will be unlikely to use expansionary policy to help one country, since doing so would cause inflation in those EMU countries not in recession." (Soto) As stated above, the Central Bank's lack of ability to accurately control the regional monetary policy and resulting inflationary rates will ultimately plague the union for some time as they try to keep this in control. The second traditional tool in government policy is fiscal policy. Although countries involved in the European Union do not lose all control and independence of their fiscal policy, the convergence criteria for the Euro states that a single country with in the Euro Zone can not have a deficit of more than three percent of it's GDP, further reducing the available room to exercise fiscal policy. (Soto) Countries are voluntarily giving up two of traditional tools to control their domestic economy by joining the single currency area.
The effects of this have been quite apparent with the deficits of 12 euro zone violating this policy or are headed in that general direction with no real plan to get out. (Soto) The purpose of such a policing mechanism seems at first self evident. Budget deficits inflate the economy. Any one of these countries violating this policy, running a chronic deficit will weaken the system as a whole.
The individual fixed exchange rate parities between the countries will be inherently worthless. (Globalist) The biggest flaw in the system is the failure of the system to recognize the difference between a structural budget and a cyclical budget. In a structural budget deficit, the country is at full employment and it still spending more than it brings in-thus living "beyond its means." In this case you must raise taxes or cut spending to balance the budget. However in the case that the European Union, a Cyclical budget deficit is where the country has less than full employment and has recessionary characteristics. In such a case, tax revenues drop through lower income and profit taxes.
The remedy is not to raise taxes or cut spending to eliminate the deficit, this will actually worsen the situation. (Globalist) The type of deficit cure stated above is first of all a recipe for economic stagnation and then for political turmoil. Its actually a double whammy of sorts. Its bad enough that common currency takes away an individual counties ability to participate in monetary and fiscal policy. But its a lot worse for the budget defect policing device to actually hurt the system more than it helps it. For the sake of Europe I hope they get these problems figured out other wise we could be looking at a major debt default and a banking crisis.
(China) Works Cited 1. JP Morgan, (1999). Euro. On line: web China Business Weekly, (2004).
Euro failing to fulfill its huge potential. On line: web 3 Soto, Mauricio. (1999) History and Implications of a New Currency. http: /europa. eu. int / euro /4 Feldstein, Martin.
(2004) Why Europe is not an optimum currency area. , web The Globalist, (2002). Why the Euro Will Fail. Online: web 6 Urwin, D. (1991). The community of Europe: A history of European integration since 1945.
London: Longman Group.