The Euro: Its Purpose, Effectiveness, and Feasibility

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In the days following the end of World War II, Europe found itself in a financial disaster. Bombed factories, torched farmland, and torn up cities littered Europe, and the war destroyed trade between nations. Germany’s money was worthless and the other countries’ currencies did not fare much better. Europe needed a solution to their economic problems, and so it formulated a plan to create a universal currency: the Euro. The European nations created the Euro to solve their economic problems, but some question whether the Euro actually fixed the issues that it was created to solve and whether it is still feasible today.




Eurozone Members
Eurozone Members | Source

Before the Euro, each European country maintained its own currency and economic policy. It may seem strange that these countries would consider rejecting their own economic system and authority in favor of adopting a common currency. Yet, when compared to the United States, it does not seem so unusual after all. The European countries have close ties economically, much like the fifty states in the U.S. Trade, travel, and investments among these countries occur just as constantly as those among states in the U.S. The only difference was that for each out-of-country transaction in Europe, currency exchanges were necessary which affected trade and profits. This predicament can be paralleled to each U.S. state possessing its own currency. In Europe, varying exchange rates directly affected profits. One day, a single German franc could be worth five Spanish doubloons, and the next day, one franc could be worth two doubloons. Prices and profits from trade between these two countries would vary daily due to the exchange rate. By creating a common currency, these problems disappear. “A common currency, like permanently fixed exchange rates, encourages flows of commodities, capital, and labour between states by eliminating exchange rate uncertainty and reducing transaction costs” (Eichengreen, 13). This became the main reason behind the formation of the Euro.



Other factors also contributed to the desire for a unified currency. While each country operated with its own currency, investments in other countries proved risky and cautious investors avoided them. Each economy grew sporadically and was isolated from the others. Businesses had trouble expanding without the needed investments and financial security. Each country minded to its own affairs and faced its economic problems alone. The European economy overall could not grow rapidly like its American counterpart, and that weakness showed after the devastation of World War II. After the war, the European countries recognized that the current economic system failed and that they needed a new economic plan.

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Therefore, some economic changes needed to occur before the Euro became a feasible option. The first step taken by Europe was the formation of the European Union. Formed under the Maastricht Treaty in 1993, it attempted to unite Europe economically and socially to better maintain peace and economic success. It allowed free trade amongst the member countries and attempted to regulate exchange rates. It also made immigration among the countries much quicker and simpler. This created a connected region where goods and peoples can travel freely whenever and wherever they want, just as they can in the United States. In order for this bold idea to catch on and work effectively, the economic barrier of different currencies had to be addressed. Even with regulated exchange rates and free trade, the process of any financial transactions among countries required exchanging one currency for another, which could hurt profits. “Reducing the foreign-exchange component of working balances from many currencies to one vehicle currency enables traders to reduce transactions costs and to increase the over-all return on their working balances” (Swoboda, 8). The European Union needed to find a way to simplify the financial system and solve the currency issue. Thus, the idea for the Euro came into existence. The Euro replaced all the individual currencies within the European Union and provided a single monetary system for all of the member countries. This change removed the hindering money exchange issues and made trade much more efficient.

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While the Euro simplified trade and travel within the European Union, the questions of whether it is practical to have the Euro and the European Union tied so closely together and if membership to the European Union should be necessary to use the Euro arise. One only has to look at the purpose of both entities more deeply to find the answer. As mentioned before, the European Union’s purpose became to maintain the peace in post World War II Europe and unite Europe politically and economically. It has since expanded into a massive governing system. The European Union maintains its own bank, currency, parliament, councils, court system, and infrastructure. It possesses the power to create rules and laws that all member states must follow. The European Union does not, however, rely on the Euro to perform its functions. In fact, it operated just fine before the Euro’s creation. The Euro simply removed the complications of multiple currencies and the regulations that attempted to stabilize them. The European Union did and still could operate without the Euro’s presence. All the political aspects of the Union would be mostly unaffected and the financial aspects would change very little. The Euro just makes all the operations must simpler and trade much easier.


The Euro, on the other hand, would not be a feasible option without the European Union or a similar institution. The massive overhaul of each individual currency into one single currency as well as the printing, distribution, and regulation of the Euro could only be accomplished by an entity that all the participating countries are a part of. Without the oversight of an organization like the European Union, the Euro would collapse and the financial woes of Europe would intensify. The European Union manages all the aspects of the Euro: from the printing and distribution to the regulation and lending policies. Therefore, it makes sense that the Euro is tied so closely to the European Union.


In order for countries to adopt the Euro, several measures must be accomplished before the European Union allows it. With the exception of England and Denmark, all members of the European Union must adopt the Euro when all the prerequisites are fulfilled. The European Union has allowed non-member countries, such as Kosovo and San Marino, to join the Euro-Zone as long as they accomplish the prerequisites as well. The criteria to join the Euro-Zone is called convergence criteria. It requires “price stability, to show inflation is controlled; soundness and sustainability of public finances, through limits on government borrowing and national debt to avoid excessive deficit; exchange-rate stability, through participation in the Exchange Rate Mechanism (ERM II) for at least two years without strong deviations from the ERM II central rate; and long-term interest rates, to assess the durability of the convergence achieved by fulfilling the other criteria” (Who Can Join and When). The Commission and the European Central Bank, which monitors these areas, uses several factors in the candidate country’s economy to determine whether it meets the criteria. The country’s debt and deficit compared to its Gross Domestic Product, the long term interest rate, the consumer price inflation rate, and the amount of deviation from the central rate all help the EU gauge the completion of the convergence criteria. The main purpose of the criteria is to ensure that the candidate country can maintain a steady economy void of excessive inflation or exchange rates and can easily adapt to the euro-zone economy.

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Even with set criteria to join the euro-zone, many complications have arisen. The major issues took place at the creation of the euro. The idea of uniting individual and independent countries each with distinct and vastly different economies proved daunting. Not only did these countries need to have stable economies, they also needed to have governments that could cooperate with each other and would be compatible with the new system. To confront this problem, the European Union developed a program that tweaks a candidate country’s government so that it can integrate itself into the European Union more smoothly. “A country that plans to join the Union must align many aspects of its society – social, economic and political – with those of EU Member States. Much of this alignment is aimed at ensuring that an accession country can operate successfully within the Union’s single market for goods, services, capital and labour” (Adopting the Euro).The European Union attempts to unify all the countries that enter into its political or economic program. It modifies society for membership into the European Union and demands a strong and stable economy for the use of the euro.


After the completion of the steps, the adoption process commences. The process undertaken by the original European Union members to first adopt the euro is referred to as the Madrid Scenario. This scenario took place over a period of four years in three steps. The first step permanently fixed the exchange rate between each individual national currency with the euro. During step two, “the euro became the official currency of the participating countries. The national currency units became 'sub-units' of the euro, and national banknotes and coins remained in circulation. Consumers saw dual price displays in euro and the national currency units, but euro cash was yet to be made available. Governments, financial institutions and companies began operating in euro. The euro was in widespread use as ‘book money’ and as a unit of account” (Scenarios for Adopting the Euro). The third and final step created euro money in the form of bills and coins and phased out the national currencies. All of the member countries that adopted the euro at its creation followed this process.

Countries that later qualified to adopt the Euro could follow the Madrid Scenario or had to other options. The first option, the Big Bang Scenario, provides for the immediate use of euro money and allows dual circulation for six months. The second option mimics the Big Bang Scenario but gives the country an additional six months of dual circulation. This option is generally used as a fall back option if difficulties arise implementing the first.

Country
Year of Entry into Eurozone
Austria
1999
Belgium
1999
Cyprus
2008
Estonia
2011
Finland
1999
France
1999
Germany
1999
Greece
2001
Ireland
1999
Italy
1999
Luxembourg
1999
Malta
2008
Netherlands
1999
Portugal
1999
Slovakia
2009
Slovenia
2007
Spain
1999
Information taken from http://en.wikipedia.org/wiki/Eurozone


Even with all these steps to prepare a candidate country for membership in the European Union and for the use of the Euro, some still question whether the Euro was a reasonable solution to Europe’s problems. By examining the Euro’s benefits and shortfalls, one can determine its practicality. The Euro does possess many benefits that make it seem like a great solution. It helps maintain stability and consistency in the financial system. It unites countries and forces them to work together for a common good. It has given businesses the opportunity to grow and individuals the ease to travel and work throughout the European Union, so it appears to have fulfilled its goals. Yet, the Euro does contain some shortfalls. It takes away the countries’ autonomy in financial matters. “In response to country-specific shocks, governments will no longer have the option of pursuing a monetary policy which differs from that of the union as a whole. Insofar as monetary policy is useful for facilitating adjustment to disturbances, adjustment problems may grow more persistent and difficult to resolve…hence all important fiscal instruments may be constrained. The sacrifice of monetary autonomy is potentially all the more serious” (Eichengreen, 35). As long as all the countries’ economies fare the same, the overall monetary policy will benefit everyone. However if one country’s economy struggles while the other countries’ economies grow, that one country is limited to fixing its problems through financial means and must struggle on alone.



The European Union also faces difficulties in establishing a monetary policy as banks can easily dodge attempts to regulate the economy. “Attempts of monetary authorities to restrict credit expansion may be hampered if commercial banks, having accepted dollar deposits available in the market, convert them into local currency for loans to domestic borrowers…A policy of monetary contraction may be impeded also by banks and corporations pulling back their placements in the Euro-dollar market” (Klopstock, 20). Likewise, “Easing monetary policy trying to add domestic liquidity and credit may be inhibited because it would at the same time exert a stimulus to placement of funds in Euro banks abroad” (Klopstock, 20). While the European Union has tried to establish restrictions to help enforce its monetary policies, authorities are hesitant and incapable of removing these problems from the system.



The problems do not stop there. According to economist Helmut W. Mayer, the Euro is heavily dependent on the dollar and other foreign currencies and cannot stand by itself as a sole entity. Thus, “A euro dollar flow cannot lead to an improvement or deterioration in one countries payments balance on an official settlements basis without entailing a corresponding deterioration or improvement in another countries balance” (Helmut, 4). Basically, a payment beneficial to one country must be detrimental to another due to the way the flow of the euro dollar works and its connection to other currencies.


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These weaknesses of the Euro have manifested themselves in the current economic crisis occurring in Greece, Spain, and Italy. In 2011, Germany began experiencing increasing inflation. Therefore, the Central European Bank increased interest rates without regard to the recessions occurring in Greece, Italy, and Spain. These three countries also possessed much larger debts than the rest of the member countries and the Euro market lacks incentives to practice fiscal accountability. Instead, it actually sends a message of false security in that the other member countries will just bail out the struggling country. Lastly, the Euro is incapable of devaluing, which may seem good at first glance. However when a country’s exports become uncompetitive due to rising labor and resource prices or lower priced competition, the devaluation of the currency restores competitiveness. Without this corrective measure, exports fall, revenue decreases, and national debt skyrockets. These failings of the Euro helped cause the debt crisis that occurred with Greece, Spain, and Italy, and threatens the stability of the Euro-zone.

Despite the apparent failure of the Euro and the predictions of its demise, the Euro should still stand as the uniting currency and rebound. Sure, the crisis was partially caused by the weaknesses of the Euro, but the irresponsible spending habits of the member countries and failure of oversight are to blame as well. Recklessly spending more money than what one can afford will cause a financial meltdown regardless of the currency. Every currency cycles through periods of growth and decline, some more drastic than others. Yet with proper corrective measures, the Euro will rebound in the future


One must also take a look at the Euro’s relationship to the rest of the world. The Euro’s purpose was to unite Europe, but some claim that it isolated the countries that do not use the Euro from those that do. Some also attest that the Euro will cause problems to the global economy. The answer to the first claim by critics can be found by examining England and Denmark. Both of these countries obtained exceptions to adopting the Euro. While the rest of the Euro-zone experienced economic hardships in 2011, these countries’ economies remain quite strong comparatively. Clearly, one can still be a member of the European Union and yet avoid using the Euro and still maintain a strong economy. In respect to the world economy, economist Alexander K. Swoboda argues the Euro offers a positive influence to the world money supply. “First, when an expansion of the Euro-dollar market reflects an increase in the efficiency of financial intermediation in the world, it reduces loan rates and increases deposit rates and, hence, increases the share of bank deposits in wealth owner’s portfolios. Second, to the extent that the process of multiple expansion takes place in the Euro-dollar market itself, no reduction of claims on the American banking system need occur…the transfer of a deposit from…to the Euro-dollar market always leads to an increase in the world money supply” (33). An increase in the world money supply means an increase in economic activity. Many economists also state that the Euro breaks the American monopoly as a reserve currency which, in a world prospective, encourages competition and offers an alternative to the American dollar.



Yet, the Euro can also harm the world economy as it did with the crisis of 2011. On the other hand, any major economic crash causes world-wide repercussions. For example, the economic crash in America in 2008 started a world-wide recession that may have spurred on the problems in the Euro-market in 2011. With all things considered, the Euro does not project any more problems than any other currency and offers many benefits to those inside as well as outside the Euro-zone.


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The final question that lingers within many economists’ minds today remains whether the Euro is still practical today or does it need to be reformed or done away with. In light of the many problematic loopholes and oversight issues combined with the economic crisis of 2011, decisive reforms are needed. Nonetheless, the destruction of the Euro would cause more harm than good as the massive restructuring of the entire European economy would ensue. With any economy, periods of growth and decline cycle constantly, so the Euro will eventually rebound and the economic health of Europe will improve. A Bloomberg article states: “Their [currencies] performance cannot be judged after five or 15 years…There is no doubt that fiscal discipline has been lost, but that does not mean the problem can’t be fixed. In fact, the governments involved believe that it can be fixed, right now…policy makers now exhibit a zealot-like faith that the necessary discipline can be established over the next two or three years…The euro will survive if the flaws are eventually fixed, but we’ll probably have to wait a few years or decades to know” (Wyplosy). While the Euro has experienced some difficulties, it has also gone through periods of rapid growth, so the argument leans toward the survival of the Euro.



The Euro, while not the perfect solution to Europe’s financial difficulties, has accomplished the amazing feat of uniting Europe economically. It has succeeded in its goals of creating a common currency, increasing trade and cooperation, and getting rid of profit-reducing exchange rates. The Euro’s benefits outweigh the shortfalls and even though it is struggling now, its future looks bright. Overall, the Euro has been a major accomplishment for Europe and, with some reforms, will continue to be a success for Europe.


Sources


Dufey, Gunter, and Ian H. Giddy. The International Money Market. Englewood Cliffs, NJ: Prentice-Hall, 1978. Print.


Eichengreen, Barry J. European Monetary Unification: Theory, Practice, and Analysis. Cambridge, MA: MIT, 1997. Print.


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"Who Can Join and When." Economic and Financial Affairs. Web. 04 Apr. 2012. <http://ec.europa.eu/economy_finance/euro/adoption/who_can_join/index_en.htm%20>.


“Adopting the Euro." Economic and Financial Affairs. Web. 04 Apr. 2012. <http://ec.europa.eu/economy_finance/euro/adoption/index_en.htm>.


"Scenarios for Adopting the Euro." Economic and Financial Affairs. Web. 05 Apr. 2012. <http://ec.europa.eu/economy_finance/euro/adoption/scenarios/index_en.htm>.


Helmut, Mayer. "Some Theoretical Problems Relating to the Euro-Dollar Market." Essays in International Finance 79 (1970). Print.


Klopstock, Fred. "The Euro-Dollar Market: Some Unresolved Issues." Essays in International Finance 65 (1968). Print.


"Some Problems with the Euro." Web. 06 Apr. 2012. <http://econ.economicshelp.org/2008/04/problem-with-euro.htm>.


Stem, Carl H., John H. Makin, and Dennis E. Logue. Eurocurrencies and the International Monetary System. Washington: American Enterprise Institute for Public Policy Research, 1976. Print.


Swoboda, Alexander. "The Euro-Dollar Market: An Interpretation." Essays in International Finance 64 (1968). Print.


Wyplosz, Charles. "Euro-Doom Is Fantasy, Why the Currency Won’t Collapse." Bloomberg. Web. 07 Apr. 2012. <http://www.bloomberg.com/news/2012-04-01/euro-doom-is-fantasy-why-the-currency-won-t-collapse.html>.


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