Lower Transaction Costs And Exchange Rate Risk example essay topic

EEC and the Euro Dollar The European Economic Community (EEC), also known as the common market, was established in 1957 through the treaty of Rome signed between Belgium, France, Italy, Luxembourg, the Netherlands, and Germany in order to achieve economic cooperation. "It has since worked for the free movement of labor and capital, the abolition of trusts and cartels, and the development of joint and reciprocal policies on labor, social welfare, agriculture, transport, and foreign trade". Over the years, monetary union has been suggested by the members of the EEC and was finally attained on January 1, 1999 when eleven European countries, which are now collectively referred to as Euroland, introduced a single currency, the euro. Since then, the euro has invaded nearly every sector of the world economy. The monetary revolution embodied in the euro involves far more then the elimination of 11 currencies and the distributions of colorful new banknotes and coins across Europe.

"It entails the solidification of the European Union's common market for goods and services, major structural changes in countries plagued by fiscal imprudence, and the reorganization of monetary policy in some of the world's most advanced industrialized economies" The risks of implementing the euro consist of supply shocks and political discord. Although the ongoing risks of maintaining Economic monetary union may hinder the stability of the euro in the long run, the integration of the euro to the EEC as of January 1999, has so far proven to have a positive affect on the European economy and has allowed it to achieve its primary political and economic goals through its four core benefits: the reduction of transaction costs, the elimination of exchange rate risks, increased price transparency, and the creation of deep financial markets. The Euro is the newly created currency of the European Economic Community, a currency that became legal tender on January 1, 1999. By 2002, euro notes and coins will replace the Austrian schilling, Belgian franc, Finnish markka, French franc, German mark, Irish punt, Italian lira, Luxembourg franc, Dutch guilder, Portuguese escudo, and Spanish peseta. These 11 nations will share a common currency, a single monetary policy, and a single foreign exchange rate policy. Currencies not only serve as a standardized value of measurement, so that we have a consistent way of expressing value, but they also function as an efficient means of payment.

Also they serve as a store of value, allowing us to transport wealth easily over a distance and to store it for indefinite periods of time. There are two main reasons for this monetary union within the EEC (European Economic Community), one being a political reason and the other an economic reason. The political arguments are that a single currency will further unite the European alliance, which was formed after WWII, by forcing Europe to act as a whole rather than as single states. This could perhaps eliminate nationalism and bring unity to this continent, which has been plagued by war twice in the last century.

The Economic reasons for the euro project can be found in the relatively poor performance of the European economies over the last twenty years or more. Europe has, for a long time, suffered form relatively weak economic growth. "Economic growth that trailed behind that in North America and Asia: productivity gains were weak; unemployment remained persistently high; and many European countries suffered form persistently high wage and price inflation. This was generally thought to be caused by relatively rigid and inflexible labor markets; a high level of government involvement in the economy; a less enterprising culture compared, in particular, to that in North America; and a poorer track record of innovation and research and development". The euro has given Europe one of the largest and most powerful trading blocs in the world. Although the euro doesn't alter the fact that Euroland is composed of diverse and highly independent countries, it strengthens the economic and political ties of the region and its part in the world economy.

Because of the success of the euro will ultimately be determined by the collaboration of EEC governments through the formulation of exchange rate policy to the harmonization of legal systems and security policy, the concept of western Europe as a single economic and political bloc is now more applicable than ever. The euro creates the second-largest single currency area in the world, one that follows the United States in total output. When and if Great Britain, Sweden, Denmark, and Greece join the euro area, Europe will easily surpass the United States in total economic output. Already, Europe is home to more people who are united by a single currency than is the United States or Japan. Whereas the costs of a common currency have much to do with the macroeconomic management of the economy, the benefits are mostly situated at the microeconomic level.

Eliminating national currencies and moving to a common currency can be expected to lead to gains in economic efficiency. The euro's four primary and direct benefits are: the reduction of transaction costs, the elimination of exchange rate risk, increased price transparency, and the creation of deep financial markets. The first benefit that has come about as a result of the integration of the euro into the EEC has been the elimination of exchange rate risk. In the international business environment, decisions made today are often adversely affected by future shifts in exchange rates. The more unpredictable exchange rates are, the more risky are foreign investments and the less likely companies are to pursue growth in foreign markets. By replacing European national currencies, the euro eliminates exchange rate risk between participating currencies.

This will be a bonus to international investment in Euroland. Exchange rate risk is potentially troublesome to any consumer, producer, or investor who makes an economic decision today that results in a payoff, or the delivery of the good or service at a later date. Firms have often used hedging techniques in order to protect themselves from these fluctuating exchange rates. By hedging, firms buy the right to exchange foreign currencies in the future for the price that prevails today.

But hedging has a price, just as any insurance policy has a price. It is not free and is not available to every business. A second benefit of the euro has been the elimination of transaction costs. Tourists planning European excursions before the euro found themselves with the hassle of many currencies, "each recognized by a small geographic segment of the European Union, and exchangeable only through banks, traveler service offices, and credit card companies for a fee". The euro eliminates these transaction costs. "It is difficult to estimate exactly how large the euro's transaction cost savings will ultimately be, but for Europe, a continent in which international trade is vitally important, the savings will be substantial.

One European Commission study estimates that, before the euro, European businesses converted $7.7 trillion per year from one currency to another, paying $12.8 billion in conversion charges, or 0.4 percent of European Union GDP". Increased price transparency is a third benefit of the euro. A single currency makes price difference between goods, services, and wages in different countries more evident. Before the euro, Euroland consumers found it difficult to compare the prices of goods across national boundaries. As a result price discrimination was implemented. No longer will consumers have to think in terms of which exchange rate to apply and the transaction costs involved in switching between currencies.

The price of the good will be set in euros in all of the countries in the euro area. "This transparency will be coupled with the greater freedom of movement of goods and services within the single market an the overall effect should be to encourage competition and drive prices lower". This will be a disadvantage to retailers who will find it increasingly difficult to differentiate prices between markets. Due to the absence of exchange rate risks, entrepreneurs feel more comfortable establishing businesses that take advantage of small differences in cross-border prices.

Also, some claim that these price transparencies created by the euro will eliminate continental price differences for identical goods and services. However this is incorrect since prices are determined by the interaction of supply, demand, and regulation in a wide variety of competitive environments. Therefore, the introduction of a common currency in Euroland does not eliminate price differences. Finally, the creation of deep financial markets is the fourth and last direct benefit of the introduction of the euro. "Before the euro, efforts to match the immediate financial needs of consumers with the investment requirements of savers were plagued by the psychological and economic costs of 11 national currencies". Every type of financial device such as government bonds, commercial bank loans, and stock was listed in a national denomination.

This fractured financial markets and discouraged foreign investment and would have done so even without transaction costs and exchange rate risks. The euro revolutionizes this situation. Since January 1, 1999, Euroland's major exchanges have listed their financial instruments in euros. To investors and borrowers, such developments have made the European financial markets broader, more accessible, and more liquid.

Because this promotes unrestricted international trade in the world's single most important market, the market for money itself, it is considered one of the euro's core economic benefits. Together with the four primary and direct benefits attained from the euro, there are also other economic benefits that are more indirect. They involve: macroeconomic stability, lower interest rates, fundamental structural reform, the creation of a new global reserve currency, and increased economic growth. The euro has brought macroeconomic stability to unstable European nations. Many of the EEC's fifteen member countries have battled inflation. "This confuses buyers and sellers, increases borrowing costs, raises the effective tax rate, sends negative signals to investors, and creates gross market inefficiencies".

However, the euro has introduced a new regime of low inflation and macroeconomic stability from many Euroland countries. According to some experts, this is virtually guaranteed because Euroland now possesses the most independent central bank in the world, the European Central Bank (ECB). Central banks steer a country's inflation rate by using a variety of monetary policy instruments to lower or raise the general level of demand. The more independent a central bank, the less likely it is to succumb to the political pressures of its government to allow an economy to grow too fast or to finance excessive public expenditures which in turn leads to lower inflation.

Yet history has shown that the central banks of many Euroland countries are not immune form political influence. That is precisely why the euro may be able to maintain long-term regional stability. Lower interest rates are another one of the larger economic goals that the EEC is hoping that the euro will achieve. To the extent that the euro lowers inflation, it also exerts downward pressure on interest rates.

Investors buy bonds only if they are sure that the money they receive in the future will result in a percentage return that is higher than the inflation rate. Investors consequently demand lower interest rates from countries with greater price stability. This benefit is particularly important for countries with poor inflation-fighting records. These countries now benefit form reduced inflation expectations because of the tight goals and determination of the new European Central Bank. Also, the euro brings lower interest rates by reducing exchange rate risk.

The euro encourages structural reform in Europe. Countries wishing to qualify for the euro had to push their economies into shape by meeting the convergence criteria set forth in the Treaty on European Union. The criteria outlined in the treaty are: countries must have a rate consumer price inflation no more than 1.5 percent above that of the three countries in the EU with the lowest such inflation; countries must have a ratio of general government borrowing to GDP no greater than 3.0 percent; countries must have a ratio of gross government debt to GDP no greater than 60 percent; countries must have a nominal interest rate on long-term government bonds no more than two percent above that of the three EU members with the lowest such rate; and countries must be members of the European Monetary System and their currencies must trade within the normal margins of fluctuations of that system. This criteria was created to ensure that any country joining monetary union was fiscally responsible and that participating countries agree to a single monetary policy. In the future, countries that have qualified to be a part of Euroland must adhere to the Stability and Growth Pact, an agreement that strictly limits government borrowing and forces governments to shape up their public finances.

The pact also fines countries that borrow too much. "The euro is modernizing European economies, shrinking the size of their welfare states, and encouraging a modern, global view". There exists the possibility that the euro will become a major international reserve currency. Reserve currencies are use by central banks, governments, and private firms worldwide as long-term store of value and to meet their ongoing financial requirements. The dollar is currently the world's premiere reserve currency. Historically only currencies that are highly liquid, stable, and accepted as payment in a large economic area have the potential to become major reserve currencies.

Reserve currencies are highly demanded and therefore benefit from high liquidity and extremely low transaction cost in foreign exchange markets. Reserve currency status similarly benefits a nation's securities markets, because buyers interested in holding a reserve currency buy assets denominated in that currency. This in turn lowers the cost of borrowing for firms and governments raising money in that currency. The advantages of having a currency, which is used as a unit of account and a medium of exchange in the rest of the world, are significant.

There are two benefits. First, when a currency is used internationally, the issuer of that currency obtains additional revenues. For example, in 1999 more than half of the dollars issued by the Federal Reserve were used outside of the USA. This doubles the size of the balance sheet of the Federal Reserve. Therefore the profits double and go on directly to the US government. In turn citizens enjoy the benefits of the worldwide use of the dollar in the form of lower taxes needed to finance a given level of government spending.

If the euro reaches the same level as the dollar, citizens of Euroland will enjoy similar benefits. Also if the euro becomes an international currency, activity will boost for domestic financial markets. "Foreign residents will want to invest in assets and issue debt in that currency. As a result, domestic banks will attract business, and so will the bond and equity markets.

This in turn will create jobs". Therefore if the euro becomes an international currency like the dollar, there will likely be the creation of new opportunities of financial institutions in Euroland. Finally, the euro has also encouraged economic growth within the European Economic Community. Lower transaction costs and exchange rate risk, coupled with price transparency and a single means of payment, have increased the effective size of the product markets across euroland.

As a result, some multinationals can now achieve economies of scale, which is "the ability to produce products at a lower average cost than competitors due high volume". Economic historians know that economies of scale have been a key determinant of the United States industrial success for centuries. Euroland now hopes to benefit form the lower average costs, higher productivity, and enhanced competitiveness promised by a large internal market. Although the euro has proven to be successful since it was integrated in January 1999, there are two major ongoing risks associated with monetary union.

These risks are not one-time costs that will soon disappear. Instead, they will threaten the sustainability of the euro for decades to come. These shocks involve susceptibility to economic shocks and political discord. Economic shocks are "unexpected changes in the macroeconomic environment of a country or region that disrupts the careful balance of production, consumption, investment, government spending, and trade". The most threatening type of economic shock for the single currency area is known as an asymmetric shock, so called because such shocks affect countries unequally. They can be caused by sharp declines or increases in demand for the primary goods and services of a specific country.

"Before the arrival of the euro, Euroland countries could handle asymmetric shocks and the recessions that often followed them in three primary ways: interest rate adjustment, exchange rate intervention, and fiscal adjustment". Of these, interest rate adjustment was the most important. The euro, however, makes independent interest rate adjustments impossible, because Euroland's national central banks surrendered monetary policy authority to the European Central Bank in Frankfurt as of January 1999. There is now a single set of short-term interest rates for all euro participants. Therefore, unless economic shocks hit all eleven countries part of the Economic Monetary Union simultaneously, interest rate adjustments cannot be used to manage them.

The second major way in which economies recover from asymmetric shocks is through exchange rate adjustments. Yet for individual countries, the euro eliminates this monetary policy instrument, because the euro is now the common currency for eleven different countries. Therefore, currencies can no longer be devaluated at the national level. Another way in Euroland economies dealt with asymmetric shocks before the euro was through fiscal policy adjustment. Usually, when asymmetric shock send a country into recession, government spending increases. As a result governments go into debt during difficult economic times so that they can spend more money on social programs.

Such spending introduces large amounts of money into an economy, increasing consumption and economic growth once again and pushing the economy out of a recession. However, the euro restricts such fiscal stabilizers because members must adhere to the new Stability & Growth Pact, an agreement which requires all Euroland government budget deficits to be less than 3.0 percent of GDP. Therefore, it is evident that the euro has three primary impacts on the ability of countries to respond to asymmetric shocks: "it precludes independent interest rate movements: it prevents currency devaluations; and it restricts the ability of government spending to stabilize and economy". There is a second major ongoing risk to monetary union.

It stems form the fact that European political integration is still not complete. This poses two significant threats to the euro. The first is that member governments may become financially wasteful. This endangers the viability of a single currency.

Any single authority does not directly control the daily spending habits of the eleven members. Therefore, some nations may exceed the annual budget deficits outlined in the Stability & Growth Pact without notice, refuse to pay their fines, and become political outsiders to the union. "In this way, fiscally conservative and stable countries may be hurt by the excessive borrowing of others, because the excess demand non the capital market of a heavy borrower push up the cost of borrowing for everyone else borrowing in euros, even though distinct national interest rates still exist". As a result this may destabilize all Euroland economies. The euro officially came into being on January 1, 1999 under the full leadership and support of eleven heads of state, thousands of politicians, and hundreds of prominent economists. Whether the euro's economic advantages outweigh the risks posed by economic shocks and political instability is unknown.

The great gamble the EU (European Union) leaders have taken is that modern Europe is entering a new era of adaptability and flexibility that ensures the success of monetary union. So far the advantages of the EMU have come through and are showing positive signs towards the probability of a well-stabilized European economy that will benefit not only domestically but also internationally through economic stability, reform, and growth. Although its success cannot be determined until the next economic downturn, the EMU (Economic Monetary Union) is one the most exciting economic events in recent history.