Economic Growth Within The Euro Zone example essay topic

Introduction On January 1 1999, 11 countries of the European Union (EU) elected to renounce their national currencies to form a single currency, known as the Euro. The new combined economy established the Economic and Monetary Union (EMU) alongside a new European Central Bank (ECB). Greece is the latest to join this bloc, becoming the 12th member state of the eligible 15 countries. The move was a significant historical event in restoring the unification of Europe that had ceased to exist since the reign of the Roman Empire, and also the largest monetary changeover to transpire. The introduction of the Euro and its economic and political effects are highly debated amongst a variety of literature. Three years since its adoption and now the official currency of 12 nations, the question that arises is what effect has the euro had both within and beyond Europe?

This paper will address whether the euro truly is an accelerator of economic growth (Noyer, 1999). In particular, our focus is directed toward the economic growth in the 12 countries that make up the euro-zone. It also examines the impact on the countries that have not joined the EMU including Britain, Denmark and Sweden. The study extends to review the future potential of the euro on the countries external to the EU. The development of the euro The concept of a common European currency has existed for some time, dating back to the end of World War II. In 1942, a paper issued by a Hitler ite professor, evoked discussions for a single currency.

Soon later, Winston Churchill similarly proposed a 'United States of Europe'. The motivation behind restoring Europe was primarily a political issue to instigate peace amongst a continent that had been divided by two World Wars (O bringer, 2001). During this time, an international monetary regime was established, referred to as the Bretton Woods system. It facilitated the exchange rate between countries by pegging currencies to the US dollar, which in turn was partly backed by gold.

Its adoption intended to revive the economic slump, which had been influenced by the war and to mitigate the recurrence of the great depression. The system proved to be effective in stabilising exchange rates and encouraging economic growth. However, the early 1970's saw the collapse of the Bretton Woods due to differing views of inflationary policy by various countries and failed attempts by the US to recover the price of gold. In light of these events, the proposal of a monetary union in Europe was again raised by the PM of Luxembourg, Pierre Werner.

In 1973, to combat the failure of the Bretton Woods system, the world's exchange rates were permitted to float freely against each other. Unexpectedly, volatility intensified as the floating rates were seen to induce de stabilising speculative trade and discouraging investments in foreign exchange markets (Cohen, 2002). This exposure to volatility hindered sustainable economic development, and thus forced the European countries to assess the stability of their own currencies. The proposed alternative management system for international foreign exchange was in the form of 'monetary unification' (Bosch ee, 1996). It raised the issue of how a single currency could work to the advantage of the countries collectively.

In general, the euro was anticipated to bring about increased economic growth within Europe, with positive flow-on effects to other economies. This is facilitated by the ECB who sets monetary policies for the involved EMU member states. How will the euro affect the economic growth within the euro-zone? The ECB has clearly defined their stance in regard to the management of the euro. The declared function of the ECB is to promote price stability within the region via the direct maintenance of inflationary levels. The implementation of the euro and the devoted policy of avoiding prolonged inflation (or equally deflation) harbour numerous economic benefits, all of which contribute to the fostering of a climate of long-term growth within the euro-zone.

In fact, the combination of low inflation, fiscal and monetary stability and the elimination of exchange rate risk, have been said to provide "the classic recipe for economic growth" (Soper, 1999). However, it is critical to note that the degree to which these benefits manifest themselves is significantly dependant on both the common monetary policy set by the ECB and the fiscal policies of the independent euro-zone nations (Duisenberg, 1999). On this notion the euro-currency system is not without it's drawbacks - in accepting the euro independent nations have in effect relinquished the monetary policy tools needed to rectify country-specific economic shocks. The primary question at this point is whether the loss of individual sovereignty over monetary policy is greater than the likely benefits associated to a single currency in relation to internal economic growth. The very nature of a single-currency and the ECB's staunch objective of price stability provide the following benefits all of which will have a catalytic impact on economic growth within the internal euro-zone.

Elimination (reduction) of currency transaction costs - the implementation of a single currency effectively removes any currency-conversion transaction costs. This represents a significant saving, it has been estimated that the transaction costs associated with the existence of different currencies within the EU were as high as 1% of GDP between 1986 and 1995 (Anonymous, 1998). Clearly the decrease in transaction costs facilitates cross-boarder trade expansion. Elimination of exchange rate fluctuations - in a similar vein, the euro eliminates all volatility and exchange rate risk. Consequently, individuals and firms are not required to divert funds from investment or other productive uses in order to hedge against the downward risk of adverse exchange rate movements. This prevents the misallocation of resources, promotes efficiency and ensures that all trade and investment dealings occur internally within the euro-zone at considerably lower transaction costs (Soper, 1999).

Price Transparency - the single currency makes the prices across the euro-zone directly comparable. This has the effect of lowering information costs as consumers and manufacturers can readily identify and secure the most competitive goods, services and factors of input within the integrated market without any further transaction or volatility costs. As a consequence, price equalization will begin to appear across boarders, increasing competition, and hence efficiency and economic development (Noyer, 1999). Price Stability - It has long been touted by national central banks that inflation and deflation are both economically and socially costly (Duisenberg, 1999). The ECB's prerogative to target and maintain low inflation will provide the following flow on effects.

Firstly, much akin to price transparency, stable inflation levels ensure the direct cross-boarder comparison of real price changes, as they are not skewed by fluctuations in the overall price level. Individuals and firms have the ability to make better informed consumption and investment decisions, prompting efficient allocation and strengthening the productive potential of the economy (Anonymous, 2001). Secondly, the assurance of price stability facilitates a potential reduction in the risk premium specifically built into real interest rates to compensate investors for long-term inflationary risk (Noyer, 1999). The subsequent reduction in real interest rates will stimulate domestic investment within the euro-zone.

Finally, the continued maintenance of price stability will dissuade individuals from diverting resources from productive uses in an attempt to hedge against inflation, which would act as a hindrance to economic growth. While the consolidated approach to monetary / fiscal policies is assumed as a necessary feature to exploit the full advantage of growth opportunities for the euro-zone, it would be na " ive to suspect that a 'one-size-fits-all' approach to interest rate policy would be beneficial in the instance of business cycle divergences between nations in the euro-zone. While fiscal policy is still within the mandate of each specific national central bank, expansionary fiscal policy is significantly hampered by the Stability and Growth Pact created in 1996 that prevents EMU countries from posting budget deficits in excess of 3% (Anonymous, 2001). The rationale behind the Pact is that lack of fiscal prudence will have an adverse affect on the fundamental objective of price stability, thus ensuring that inflation of member states are aligned to facilitate economic growth.

While it is somewhat of a major concern that euro-zone countries lose the ability to unilaterally adjust interest rates, it can be argued that this freedom can often be abused. In this sense, central bank decisions have been persuaded by the short-term political goals rather than the long-term economic health of the national economy. The general consensus is that a shared single-currency will inherently foster a 'more' independent central bank that will intrinsically cater the long-term prosperity via the primary tenet of price stability. The apparent instability of singular monetary policy and the possible existence of power differentials can be illustrated in current circumstances where the euro-zone interest rate is in favour of larger countries experiencing similar economic downturns, including France, Italy and Germany (who for 2001 experienced growth of just 0.7%, the lowest in the EU) (Anonymous, 2002). However, this is at the expense of smaller nations, like Ireland which currently faces growth of 11%, and consequently significant inflationary pressure (Are stis, 2002). In this sense, the interest rate is set at a level that accommodates to facilitate growth in slowing economies, but is insufficiently low to curb inflation in countries experiencing economic expansion (Begg, 2002).

Such analysis would prove even more problematic in the reversal of the current scenario. It is unlikely that a process of monetary expansion will be adopted for the benefit on the single country facing a recession. At these early stages of implementation, the euro system appears to be far from cohesive with countries experiencing significant cyclical deviations within the euro-zone. However, the ECB is rigorously committed to the long-term prosperity of the EMU.

These present misalignment's may be attributed to short-term 'teething problems' or a failure of complete market integration, yet economic benefits of a single currency system and the credibility of the ECB's commitment to price stability appear to adequately offset the aforementioned costs and the loss of policy independence within the EU. The effect & economic impact of the euro in countries within and out of Europe Despite these benefits, there are three member states yet to adopt the euro regardless of their approved eligibility status, including Britain, Denmark and Sweden. As the fourth largest economy in the world, Britain has not faced severe implications following the introduction of the euro. In terms of foreign direct investment (FDI), Britain attracts more investment than any other country, second only to the US. In 1998, FDI into Britain peaked at a new high, and in the first nine months of 1999, FDI was expected to break old records according to Ciaran Barr of Deutsche Bank (Anonymous, 2000). These projections indicate that the introduction of the euro has had no adverse effect on investment.

However, uncertainty among investors in regard to Britain remaining independent of the euro is increasing, causing FDI to fluctuate accordingly (Anonymous, 2000). The Prime Minister of Britain, Tony Blair, has provided support for the euro and claims that Britain "can no longer afford to pretend either that the euro does not exist or that Britain should not actively prepare for it" (Blair, 1999). Blair argues that fifty percent of Britain's trade is now with the euro-zone and that 22.5% of small and medium sized businesses claim that the euro will affect their business. Furthermore, 86% of large retailers in Britain have suppliers in the euro-zone, with many planning to pay these suppliers in euro from 1999 (Blair, 1999). From this perspective, the impact of the euro is wide and far reaching as it represents 20% of world income, as big as the US. Clearly, the economic growth of Britain may be stunted if Britain continues to delay the referendum in deciding whether the country should adopt the euro.

The rejection of the euro by Denmark in September 2000 caused varied debate as to the effects of the 'no' consensus. Many argue that Denmark's decision has marked the fact that entry into the euro is no longer an inevitability and that there is no reason why Britain, Denmark and Sweden cannot operate successfully outside the euro (Assi nder, 2000). Consequently, this has raised many fears among supporters of the euro, as a two-tier Europe could now evolve, with non-euro countries left isolated from the full economic union of the EU. The Danish currency (the krone) has been attached to the euro such that a divergence of more than 2.25% from the euro central rate will cause the ECB to intervene to support the krone (Fallesen, 1999). This fixed exchange rate policy dampens the economic reasons for adopting the euro and is believed to be the primary influence for locals and investors to reject the euro (Wallace, 2000). However, the implications in doing so has affected economic growth in Denmark as investors now demand a higher risk premium for holding the krone rather than the euro, causing increased interest rates for the Danes.

Indeed, the Danish economics ministry project that these market conditions may cause annual economic growth in Denmark to fall by 0.5% (Fallesen, 1999). To date, Sweden has chosen not to adopt the euro due to a mixture of economic and political factors. However, though Sweden is reluctant to give up sovereignty over their currency, the majority of Swedes are gradually moving in favour of the euro (Johnson, 2000). In projecting Sweden's growth over a ten year period, economists have estimated that the country's growth rate will exceed that of the EU average due to Sweden's advancement in information and communication technologies (Country Forecast, 2001). However, regardless of whether Sweden chooses to adopt the euro or not, the country will be affected by developments in the euro-zone as increasing integration of trade and financial flows is likely to impact Sweden's economic growth.

The introduction of the euro has also impacted direct investment in the euro-zone from countries such as Japan, who has accepted the opportunities for greater portfolio diversification which the euro brings (Delegation of the European Commission in Japan, 2001). Indeed, the increase in capital flows between Japan and euro countries has risen, indicating strong portfolio investments in both economies. This is confirmed by Japan's portfolio investment in euro countries totalling almost 5.6 trillion yen in 1999. Moreover, direct investment from western Europe has increased from 100 billion yen in 1998 to over 1 trillion yen in 1999 (Fujiwara, 2000). This investment indirectly promotes competition, technology transfer and the reallocation of management resources, thereby promoting economic growth.

The future of the euro Following these recent developments, several factors which are vital to the long term growth and success must be considered. These include maintaining a strong euro currency, while at the same time ensuring healthy economic growth and social and political integration of member states of the EU. Europe has long suffered from being divided and segregated. The euro is one step of many which aims to unite Europe as one economic and political power. While the long term goals of the ECB seem economically sound, their policy implementation has given rise to certain economic 'teething problems' which have been previously discussed. These problems, despite not being of a serious nature in themselves, must actually be seen in the light of Europe's situation itself.

The EU and the EMU operate as one, but consist of twelve member states, each with different languages, cultures, political ideals and economies. Faced with no fiscal independence arising from the Stability Pact, these countries must now learn to act in union to make economic sacrifices for the benefit of the euro-zone as a whole. This has the potential to create social tensions between member states and resentment towards the EU. These tensions, if left unresolved, may have adverse affects on the success of the euro, as investors may see Europe as an unstable area of investment.

Furthermore, several member-states have relaxed their policies which were adopted in order to meet the convergence criteria. "It is as though they had sucked in their bellies to fasten their belts, and are now breathing out". (Dodges 2000). These political and economic problems are magnified in present circumstances, in that the EU is in its early developing stage, and is particularly vulnerable to economic shockwaves.

Germany, as an example, has seen a decline in growth, after adopting the euro, and is now losing much confidence in the currency, with some of its leading economists expressing doubts about its entire architecture (Anonymous, 2000). In addition, the situation is likely to become more complicated in the near future, when more countries are admitted into the EU. These countries were not accepted into the EMU at its inception, as they were unable to meet the convergence criteria required, coupled with unstable political environments. As with the other countries before them, they will be required to meet the convergence criteria in order to be accepted. Therefore, it is reasonable to assume that the coming years will place further strain on the EMU and the euro. The ECB will have to carefully design policies to keep the euro strong and maintain investor confidence, while at the same time ensuring that certain needs of participating countries are not overlooked.

Conclusions - NEEDS TO BE EDITED MORE The Euro is an important step in the unification of Europe, an ideal that has existed for centuries. Since its inception in 1999, it has already established itself as an important currency in the world markets. If its success continues in the future, leading to the unification of Europe, the size of the euro-zone and the integration of financial markets indicates that the euro is likely to become a major world currency. However, the future of the Euro is still, uncertain, as there are many economic, political and social obstacles to overcome.