Economics Essay

Question:

What are the advantages and disadvantages of a single currency in Europe?

Answer:

Contents

Introduction. 2

The purpose of the European Union. 3

Balance of payments. 4

Exchange rates. 5

Austerity measures. 6

Crises within “Euroland”. 7

Unemployment rates and income per head. 9

Conclusions. 11

References. 13

Introduction

            Every national currency in today’s world is subject to similar market laws. Moreover, its value keeps changing depending on factors influencing all other currencies. In the European Union, the so-called Eurozone has been established to constitute a single currency area. All Eurozone states benefit from this situation because they are not greatly affected by the problem of fluctuating exchange rates (McKinnon, 2009). Nevertheless, the adoption of single currency in Europe presents the European Union member states with both advantages and disadvantages. The aim of this paper is to discuss these advantages and disadvantages.

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            One of the advantages is that the exchange rate fluctuations between various currencies in Europe have been obliterated . Another advantage is that transaction costs have been drastically been reduced (Hardouvelis, 2006). This is because people no longer need any other currency whenever they are travelling or conducting business within the Eurozone. Moreover, with the introduction of a single European currency, trade activities have been stimulated because there is free movement of goods, people and capital. A major disadvantage of a single currency is that whenever negative economic signals are reported in one EU member state, foreign exchange traders around the world easily generalize it to be a reflection of the economic situation across the Eurozone (Fligstein, 2006). Nevertheless, there is a need for these effects to be subjected to rigorous academic research.

            In a discussion of these advantages and disadvantages, this paper focuses on several core issues. They include the purpose of the European Union, balance of payments, and exchange rates. Other factors analyzed in this study include austerity measures, crises within the Eurozone, unemployment rates, and income per head across Europe.

The purpose of the European Union

            The purpose of establishing the European Union was to promote European integration. The founder member states of the EU also felt that there was a need for them to create a general feeling of cooperation and unity among all Europeans. Today, the EU operates not just as a trading bloc but also as a form of government (Moravcsik, 2012). The people of Europe elect their representatives to the European Parliament through universal suffrage. This parliament is made up of different political parties that represent the pan-European political environment (Alesina, 2005). In this type of government an executive of the EU government is also elected by the citizens of EU member states.

            First and foremost, the intention of the coming together of European countries to form the EU was to derive far-reaching economic benefits (Mundell, 2000). Today, these member states continue to pursue this purpose. For example, they have established the European Central Bank, which is responsible for regulating the euro as well as currency supply across Europe in just the same way that the Federal Reserve Bank does for the United States. Moreover, the EU has established a regime of an open border policy and free trade, such that it is possible for goods and services to travel across Europe (Issing, 2009). The EU also levies taxes as the main source of revenue to enable it to implement its mandate to the people of Europe.

            The European Union has also established a common defense policy intended to provide protection from war to Europeans as well as coordinate humanitarian and peacekeeping missions (Wyplosz, 2010). Furthermore, the EU has been enacting legislation on justice especially through the enforcement of human rights and constitutional law through the European Union Court of Justice. To further enhance chances of success in this mandate, the EU liaises with the departments of home affairs of respective member states to ensure that human rights are protected in each of these states. Other issues that were put into consideration during the establishment of the European Union include policies on energy, infrastructure development, education, agriculture, and environment.

Balance of payments

            One of the major reasons for the establishment of the euro as the single currency for the EU was to reduce the likelihood of occurrence of balance of payment crises within member states. The EU member states hoped to achieve this goal with the formation of the European Economic and Monetary Union (EMU), which succeeded the European Monetary System (EMS). In this move, EU member states sought to not establish a cohesive economic system but also adopt the euro as a single currency for all member states. All EU member states except Denmark and the United Kingdom have adopted the euro as their national currency.

Although the adoption of a single currency has not completely eradicated the problem of balance of payment crises, it has somewhat reduced it. However, many critics argue that the introduction of a single currency is no cure for balance of payments problems affecting the European Union (Kim, 2005). This view is based on the argument that in today’s world of numerous currencies, problems relating to balance of payments are essentially equivalent to problems with foreign exchange. Balance of payment deficits occur when a given level of growth of output and level of unemployment fails to earn a country sufficient foreign exchange through exports to provide payments for all the imports required by a country at a given exchange rate.

Britain, an EU member state that is yet to adopt the euro, has been plagued by this problem for many years. From this point of view, there is no indication that this problem would end overnight if Britain adopted the euro. Although Britain would no longer have a foreign exchange to defend, imbalances between imports and exports would still exist. It would be impossible to correct these imbalances simply through private investment and lending.  Similarly, it would be impossible to deal with this problem through inter-regional transfers provided for in the European Union.

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One major advantage is that when an economic union abandons a multiple currency system to adopt a single currency, it eliminates the outward manifestation of difficulties relating to balance of payments. This is because foreign currency reserves immediately become irrelevant. Moreover, member states no longer face the pressing need to persistently defend their respective currencies. Supporters of the single currency in the EU argue that the ability to deal with the problem of balance of payments is one of advantages of EMU that are not being emphasized on sufficiently (McNamara, 2010). The main disadvantage, however, is that even though all EU member states may be operating in a single market using a single currency, some balance of payment difficulties may reappear in a regional format within the monetary union. Today, these issues form the heart of the heated debate over sovereignty, which generates a lot of excitement within the European Union.

Exchange rates

One of the problems that the European Commission sought to address in the quest for the adoption of a single currency was that of volatility in exchange rates. In the world of business, when all other factors remain constant, this volatility can make the difference between loss and profit. The supporters of the single currency also argued that businesspeople in Europe would no longer have to go through the rigorous processes of currency conversions (Jones, 2009). The transaction costs accompanying such currency conversions were also eliminated.

One of the main disadvantages of adopting a single currency is that it comes at a high cost. The optimum currency area (OCA) theory is one of the best yardsticks for determining whether efficiencies will be achieved through the adoption of a single currency within a given geographical area (Fidrmuc, 2004). Countries that regard themselves as possessing a common destiny are better placed to accept the operating costs that come with the adoption of the OCA (Horváth & Komárek, 2002; Rose, 1994). As Frakel (1999) points out, no currency regime can be right at all times for all countries. Moreover, even after exchange rate problems have been eliminated, a single currency will always encounter occasional asymmetric shocks that trigger conflicts of interests, albeit temporarily (De Grauwe, 2005). For this reason, the EU member states should accept the economic costs of a common currency for the sake of the higher purpose.

Austerity measures

During the recent Eurozone crisis, the European Union imposed an austerity program on Greece, one of the member states worst hit by the crisis. This move was taken in an effort to restore economic health bringing down government borrowing. Two years after these austerity measures were introduced in Greece, the country’s public debt has continued to rise (Lane, 2012). At the same time, the country has been sinking deeper into depression. This turn of events has brought about far-reaching political consequences for the EU. These political shockwaves were evident during the general elections held in May 2012 when majority of Greek voters demonstrated their support for a party that has all along remained vehemently opposed to the austerity measures.

The austerity measures left the EU deeply divided, raising concerns about the future of the euro (Jovanović, 2012). Northern European government have repeatedly been accused of exerting distress on southern nations by imposing austerity measures on them, causing serious harm to their debt-ridden economies in the form of untold social turbulence (Verney, 2009). In the context of these divisions, the critics argue that if the euro now seems not worth saving, it is not because of its inherent defects but because of the way the top leaders of the European Union have behaved while responding to the Eurozone crisis (Milios, 2010).

Crises within “Euroland”

The crisis within Euroland has created the impression that the future of the euro is uncertain. According to Pisani-Ferry (2012), those who introduced the euro in 2002 did not anticipate a phenomenon where eight years later, the EU would be hit by a major economic crisis. The euro consolidated the largest trading bloc in the world. Soon, the euro was on its way to rivaling the dollar for supremacy in the global market. However, at the end of the first decade of the currency’s existence, it was threatened by the accumulation of huge public debt levels and unsustainable deficits periphery economies such as Greece and Ireland, triggering a sovereign debt crisis in the Eurozone. This crisis was critical in highlighting the economic interdependence of all EU member states. It also underscored the need for greater political integration that is necessary to provide a properly coordinated monetary and fiscal response in the event of a crisis. For the euro to be salvaged, EU leaders must work towards greater political integration for purposes of proper coordination.

It is worthwhile to point out that the idea of a single currency in the EU was modeled on the notion that greater economic integration was important for future peace and prosperity in Europe. This spirit motivated EU member states to work towards the incremental steps that would bring about economic integration and ultimately political integration. The euro is one of the most crucial symbols of this economic and political integration. For this reason, concerted efforts should be made to deal with the Euroland crisis in an amicable manner.

To deal with this crisis, it is important to first understand how it occurred in the first place. To begin with, powerful original EU members such as Germany were eager to lead the way in developing a large, competitive Eurozone (Kočenda, 2005). This was the reason why these founder members had no problem with less solvent EU member states adopting the euro. Some of these states had not even fulfilled the criteria stipulated by the Maastricht Treaty. Today, the so-called Eurogroup, which comprises the seventeen finance ministers of the Eurozone, controls entry into the Eurozone.

Many some EU member-state leaders deferred tough budgetary decisions owing to severe domestic challenges (Lapavitsas & Kaltenbrunner, 2010). They deferred these measures largely for fear of paying a high political price for such moves. Consequently, some countries, including Greece, Spain, and Italy adopted the euro without undertaking the requisite deep restructuring. The impact of these violations was not felt at first. In fact, these economies started thriving soon after adopting the euro. This growth was attributed largely to unprecedented access to Eurozone-sourced credit and overreliance on infusions of liquidity. This trend continued at a time when the periphery states’ productive capacity was being hampered by reduction in the level of competitiveness as well as rigidity in labor markets (Lapavitsas & Kaltenbrunner, 2010).

It was only after the global economic crisis that the structural issues affecting the Euroland became visible. They became visible because liquidity had all of a sudden started drying up, leaving the periphery states with massive unsustainable deficits and huge public debts that by far exceeded their GDP (Giavazzi, 2011). Three years ago, the Eurozone crisis, which had at first manifested itself in Greece, started spreading to other periphery member states such as Ireland. As the Greece crisis unfolded, it emerged that Greece authorities had tampered with the country’s balance sheet to hide some of its debt. From this explanation, it is true that the Euroland crisis occurred not because of the defects inherent in the euro itself but because of economic mismanagement and deficit spending, tax evasion, and financial misreporting by governments.

Unemployment rates and income per head

The rate of unemployment is another critical factor that plays out in a dominant way in the analysis of advantages and disadvantages of adopting a single currency in Europe. Differing academic models and competing positions have been proposed to explain why the euro is (or is not) a crucial tool for dealing with the problem of high unemployment rates in the Eurozone. The figure below (Figure 1) shows trends in youth employment rates in various EU countries between 1992 and 2012. A cursory view of this figure shows that youth unemployment rates in most of these countries have been rising to unprecedented levels since 2008. Moreover, figure 2 below shows that whereas the unemployment rate in the Eurozone has been increasing dramatically since 2011, that of the US, UK, and Japan have been decreasing considerably.  In fact, the level of unemployment has reached its highest point in the two-decade history of the European Union (See figure 2 below).  

http://static.guim.co.uk/sys-images/Guardian/Pix/pictures/2013/5/31/1369992137956/4a38392c-81f9-4159-897b-e7118fe8605d-460x252.png

Figure 1.: Youth unemployment rates in the European Union between 1992 and 2012 (Source: http://www.guardian.co.uk/business/2013/may/31/eurozone-crisis-unemployment-youth-inflation-markets).

Eurozone jobless total

Figure 2: Comparison between unemployment rates in the Eurozone, the US, the UK, and Japan (http://www.guardian.co.uk/business/2013/may/31/eurozone-crisis-unemployment-youth-inflation-markets).

            The high unemployment rates are attributed to a returned recession, persistent debt, and falling income levels. The economies of Northern Europe are more resilient while those of the south are weaker as demonstrated by their higher unemployment levels. Indications are that the introduction of the euro did not help improve the prospects of the European Union since its introduction in 2002. In fact, this is one of the main arguments made in literature against the adoption of the euro by the United Kingdom. In the absence of separate monetary policies at the national level, it becomes extremely difficult for individual Eurozone member states to put in place mechanisms of preventing debt crises from spiraling out of control like they did in 2010. For example, should Spain feel the need to introduce a new economic policy aimed at fighting back against the high rate of unemployment in the country, it cannot do so because only the European Central Bank is mandated to introduce such a policy.

            The idea of the euro also seemed to lose favor with many citizens of the Eurozone when the Eurozone crisis started impacting negatively on both income per head and disposable incomes of households. There is abundant literature on the impact of euro area membership on the relationship between public debt and GDP growth. According to Dreger (2013), scholarly evidence suggests that countries that participate in the monetary union have to contend with additional risk for their citizens in the form of GDP growth and income per head.

Conclusions

            In summary, the adoption of a single currency in the European Union comes with many advantages and disadvantages. To understand them, it is imperative for focus to be on issues of the EU’s purpose as well as matters relating to exchange rates, balance of payments, unemployment rates, and austerity measures. Evidence presented in this paper shows that it is not possible for a single currency to enable a country deal with its balance of payment problems. However, the adoption of the euro instantly eliminated challenges relating to exchange rates and related transaction costs.

            In conclusion, the idea of a single currency in the EU was a noble one. It has brought about many advantages, the most important one being ease of flow of products, capital, and services across various European countries. However, these benefits have been overshadowed by numerous disadvantages that largely arose after the founder EU member states accepted less solvent EU member states to adopt the euro even before fulfilling the criteria stipulated by the Maastricht Treaty. These so-called periphery states faced severe domestic challenges. Moreover, political leaders in these countries were unwilling to pay the high political price of fully meeting the Eurozone criteria. In the end, problems relating to economic mismanagement and deficit spending culminated into the Eurozone crisis and subsequent record-high unemployment rates. Nevertheless, once the Eurozone sovereign debt crisis is over, the euro is highly likely to regain its former glory as a symbol of political and economic integration in the EU. As De Grauwe (2005) points out in the optimum currency (OCA) theory, a single currency will always encounter occasional asymmetric shocks that sometimes trigger conflicts of interests.

References

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