The Euro - Success or Failure.docx

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The Euro:

Success orFailure?

by Ben Patterson

Briefing 6February 2006


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Introduction

Reading British newspapers, you might gain the impressionthat the Euro has been something of a disappointment.Leading economics correspondents like The Times Anatole

Kaletsky write about a currency area paralysed by tightmonetary policy and inflexible labour markets, sliding intostagnation and global uncompetitiveness.

So it should not be too difficult to answer the question: whichmajor country is the worlds most successful exporter? Surelyfast-growing, low-labour-cost, undervalued-currency, super-

competitive China?Wrong! In 2004 China was overtaken as the worlds leadingexporter by a country lying at the heart of the Euro area:uncompetitive Germany. Evaluating the Single Currencywould seem a little more complex than Euro-sceptics wouldhave you believe.

This paper examines the first six years of the Euro, andanswers some of the criticisms that have been levelled at it.

The creation of the Euro

To begin with, the implementation of EMU Economic andMonetary Union1 is in itself a major triumph. Following the

plan in the 1989 Delors Report2to reach EMU in three stages,ending with a single currency, there were predictions fromeconomists, politicians and pundits that it could neverhappen3; or that, if it did, it wouldntwork4(just as, in 1955,British Civil Servants advised the same about the EEC).

1Not European Monetary Union, as is it often mistakenly called.

2

Report on economic and monetary union in the European Community, Committee forthe Study of Economic and Monetary Union, ISBN 92-826-0655-4, May 1989.3See, for example The Times first leader on 6 October 1995: Death of an EMU.


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During the negotiations on the Maastricht Treaty the UKGovernment floated the alternative proposal of a parallelecu, to exist alongside national currencies, and eventuallyreplace them as a result of market forces. But it was too late.

The programme to merge the national currencies into a singlecurrency was already unstoppable. Instead, the UK negotiatedits opt-out our traditional policy towards Europe ofwaiting to see whether a project works before trying to join.

There followed a vigorous debate as to whether theconvergence criteria for participation in the Euro area

should be interpreted strictly or accommodatingly. Thosecalling for strictness, particularly on the reduction of annualbudget deficits below 3% of GDP, were suspicious of lettingin the Club Med countries (Italy, Spain, Portugal andGreece), arguing that the new currency had to be as good asthe D-Mark. In February 1997, 155 German economists

predicted disaster, and called for the start of full EMU to be

postponed. Yet, by March 1998, Italy, Spain and Portugal hadqualified without much difficulty (as had all twelve EUcountries except Greece); and fears that they would soondebauch the Euro through huge fiscal deficits and inflationhave proved groundless.

How could the EMU sceptics (myself included) have been

so wrong?wrote Kaletsky5.On 1 January 1999 the ten participating national currencies6ceased to exist independently, and became non-decimal

4 Papers in 1997 by Martin Feldstein, Professor Economics at Harvard, for example,described EMU as a dangerous experiment, and predicted rapid and dire economic and

political consequences.5 The Times, March 3, 1998.6 Belgium and Luxembourg already shared a currency. Greece joined in 2001.


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subdivisions of the Euro. The new European Central Bankassumed responsibility for official interest rates and otherinstruments of monetary policy. There was no disruption ofthe financial system, no turbulence on the money markets.

Similarly, at the beginning of 2002, euro-denominatedbanknotes and coins replaced the national notes and coins withnone of the widely forecast bottlenecks, unconvertedAutomatic Telling Machines, heists of lorries carrying the newnotes to banks, etc.7. Technically, as the most sceptical havehad to admit, the introduction the Euro was a tour de force.

What is a currency for?Those who travel regularly within the Euro area experiencethe most obvious success of the Single Currency: the money intheir pockets, purses and wallets is as good in one country asin another. There is no longer any need to lose 5-8% of itswapping one lot of banknotes for another at a Change or

Wechseland ending up with little stocks of low-denominationcoins8. Sceptics tend to argue that this benefit is of lessimportance as credit and charge cards replace notes and coins.

7 Great care was put into the design of -denominated notes and coins. In both cases, thespecial concerns of the blind were fully taken into account (e.g. differing milled edges tothe coins and large relief figures on the notes). Up-to-date anti-counterfeiting featureswere also incorporated into the notes, and detailed procedures for identifying and

withdrawing counterfeits established. As a result and despite widespread fears that theunfamiliarity of the currency would make it easy to pass of forgeries the amount ofcounterfeit Euros in circulation has been minimal. In 2004, for example, 594,000counterfeit banknotes were confiscated, with a value of c. 35 million, compared with the9 billion legitimate euro notes circulating in 2004, with a value of c. 501 billion.(Counterfeiting and Inflation, ECB, August 2005).8 In the mid-1980s, as the European Parliaments rapporteur on the Single Market, Icarried out a study (published in The Timeson 5 November 1987) leaving London with100, and touring the then twelve EU capitals. In each the money was changed into local

currency, but none spent. How much would be left on returning to London? The answerat the time was 55.50. Many similar exercises were subsequently carried out, yieldingeven greater losses.


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Using plastic, however, does not end exchange costs. Rather,it disguises them.

The argument also misses a fundamental point. What, after all,is the function of a currency? Over the years, theoretical

economists have endowed the concept of money with almostmystical properties. Basically, however, it is a system ofmeasurement: it enables people to estimate relative values in

buying and selling, and to store their savings. As in the case ofall measurement, the wider the interaction between groups andsocieties, the greater the value of uniform standards

The counter-argument that calculators and computers enablepeople to get behind the veil of money and work out realcomparative values misses the point.It could be used just aswell against the general use of a decimal base in mathematics.

The economic application is the theory of optimum currencyareas (OCAs). Briefly, this states that economies should have

a single currency if the costs of having different ones(exchange risks, transaction costs, the standing temptation forgovernments to inflate their way out of trouble, etc.) outweighthe advantages (the ability to de/re-value or float the currency,the ability to set independent interest rates, etc.) A morespecialised outline of the theory is given in the Box on page 6.

Stability and InflationThe concept of money as a system of measurement also helpsin understanding why price stability was made the overridingobjective of Euro area monetary policy. There is generalagreement that rapid depreciation of a currency externallythrough devaluation, internally through inflation severelydamages the utility of a currency and the economy using it, aswell as enabling governments to defraud those who have lentthem money.


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The theory of Optimum Currency Areas

The initial formulation of what should determine the geographicalcoverage of a currency was a paper published in 1961 by Nobel

Prize winner R. Mundell9. Since the purpose of money was to be"a convenience", the ideal currency area was "the world.

Given the practical need for stabilisation policies in existingeconomies, however, an area needed a separate currency if, in theevent of some macroeconomic shock, the costs of adjustmentthrough changes in wage and price levels, or through factormobility (labour and capital), would be higher than those ofaltering the exchange rate.

R.I. McKinnon10added that exchange rate policy was in any casean inappropriate instrument of adjustment for any small, openeconomy trading a substantial proportion of GDP.

Any two countries reacting to a shock in the same way i.e.symmetricallyand trading significant proportions of their GDP

bilaterally, should therefore fix their exchange rates or form acurrency union. Milton Friedman had already observed in 1953that a group of countries

"all of which firmly adhered to, say, the gold standard wouldthereby in effect submit themselves to a central monetary

authority, albeit an impersonal one. If, in addition, they firmly

adhered to the free movement of goods, people and capitalwithout restrictions, and economic conditions rendered such

movement easy, they would, in effect, be an economic unit for

which a single currency. would be appropriate" 11.

9 Mundell R., "A Theory of Optimum Currency Areas", American Economic Review,

1961.

10McKinnon R.I., "Optimum currency areas",American Economic Review, 1963.11Friedman M., "The Case for Flexible Exchange Rates" in Essays in Positive

Economics, Chicago, 1953.


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At the same time, it has also been argued that a zero rate ofinflation is not necessarily a wise target: new products andchanges in the quality of goods make price indexes an inexactscience. Critics of the ECB have indeed accused it of sado-

monetarism: of trying to establish a track-record for super-stability at the cost of low growth and high unemployment.

Yet this has clearly not been the case. In practice, the Bank hasaccommodated a more-or-less stable inflation rate of around2%, setting official short-term nominal interest rates in thehistorically low range of 2-4%, and expanding the money-

supply (M3) within an annual 4% to 9% range (thoughtargeting a 4.5% rate of expansion).

At the same time, this policy has been spectacularly successfulin pursuing long-term price stability. The most importantindicator, in this respect, is not the level of current inflation,

but the level of inflationary expectations, as indicated by theyield curve on government bonds. As the ECB proudly pointsout, the markets seem entirely confident that the Euro willremain stable for as far ahead as they predict forward.

The International Dimension

One of the strongest arguments deployed in favour of EMUduring the 1990s was that it would insulate the EU from

international financial storms. In a world of free capitalmovements, in which the turnover on the foreign exchangemarkets was over $1000 billion a day, there was always thedanger of massive speculative pressures on individual nationalcurrencies. The crises of the European Monetary System in1992/3 (including Black Wednesday when Sterling and theLira were forced out of the system) had taught the lesson that

fixed exchange rates systems were not enough12. Taken as12

Or, in the words of PM Thatchers economic advisor, Prof. Alan Walters, half-baked.


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separate currency areas, Member States traded over 30% oftheir GDP externally. As a single currency area, this would fallto around the US figure of 10-12%.

Added to this was the more questionable motive of having a

currency that would look the Dollar in the face, rivalling itas the currency of international finance (much was made, forexample, of the fact that oil is priced in Dollars).

EMU has clearly succeeded in meeting the first objective.There have been no destabilising runs on the French Franc orthe Italian Lira, or sudden surges in the value of the D-Mark,

because these currencies no longer exist. The ECB has beenable to emulate the USs Feds policy of benign neglect: theexternal parity of the Euro has played a less importanteconomic role than those of the national currencies it replaced.

This helps explain the apparently supine response of the Bankto the unexpected fall in the Euros exchange rate against the

Dollar between 1999 and mid-2001. The most convincingexplanation for this fall is that advanced by the Bank forInternational Settlement:

the newly created euro may have proved too successful.Larger and more liquid markets, along with relatively lowinterest rates, encouraged the issue of euro-denominated

bonds whose proceeds could then be exchanged and usedto finance investment elsewhere13.

As Delors himself observed, EMU was indeed transformingEuropes financial markets more quickly than anticipated byall but the most fervent euro-enthusiasts14. The best examplewas the rapid integration of government bond markets; but as

13 BIS 70th. Annual Report, Basle, 5 June 2000.14

InDer Euro und Europa, Deutsche Bank and Weiss Verlag, 2002.


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impressive was the growth in the corporate market in 1999euro-denominated issuances rose by 300%.

Since 1999, the share of the euro in the amount outstanding ofinternational debt securities has increased from 21% to 31%15,

and about 20% of official foreign exchange reserves are nowin Euros (in part because of its recovery against the Dollarsince 2001). The Dollar is still the worlds most importantcurrency. But the Euro is a respectable second, and rising.

Some criticisms

It is an interesting feature of discussions on the Euro that apart from the charge of ECB sado-monetarism mostcriticisms are levelled, not at the management of the currencyitself, but at the policies of Euro area national governments.Indeed, one of the most persistent critics has been theEuropean Central Bank itself, whose Monthly Bulletinsrepeatedly complain of national fiscal laxity and failure to

carry out structural reforms.

1. The Stabi l i ty and Growth Pact

No feature of EMU has generated more bad publicity andSchadenfreudethan the so-called Stability and Growth Pact.Contrary to widespread belief, the Pact was not part of theMaastricht Treaty, but was negotiated and adopted by the

Council of Finance Ministers in 1997 to strengthen theTreatys excessive deficit procedure. Where the Treatyrequires national budget deficits to be normally below 3% ofGDP, the Pact calls for budgets close to balance or insurplus over the economic cycle. It also toughened up thesanctions against erring governments. The driving force was

the German Finance Minister of the day, Theo Waigel.15

SeeReview of the International Role of the Euro, ECB, January 2005


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While most Euro area countries have stuck to both Treaty andPact rules, some have not. In particular, the two largest EUarea economies, France and Germany, have for some years insuccession overshot the 3% deficit limit. The possibility of

sanctions, proposed by the Commission (as it was legallybound to do), produced a revolt by the Finance Ministers(ECOFIN) particularly those of France and Germany whodemanded a re-interpretation of the Pact to make it moreflexible. Cyclical factors should be emphasised in calculatingdeficits, and more attention focused on the level andsustainability of overall public debt. A legal wrangle endedwith the Ministers more or less getting their way16.

These events have given rise to two schools of criticism.

The first, widespread at the time (2002/3), held that thecollapse of the Pact heralded the collapse of the Euro itself.Some economists have indeed always argued that it is not

possible to operate a system where monetary policy iscentralised, but fiscal policy decentralised.

The second school encompassing, in particular, Keynesianeconomists has argued that the initial provisions of the Pactwere flawed, and likely to result in damaging pro-cyclicalfiscal policies (e.g. obliging countries to raise taxes and cut

public expenditure during a recession). The idea of fining

countries with excessive deficits, so making the situationworse, was held to be absurd17.

16 The ECOFIN Council adopted, on 20 March 2005, a report on improving theimplementation of the Stability and Growth Pact, setting out proposals for reform, whichwere subsequently endorsed by the European Council. The Council Report now forms

part of the Pact. But the changes have not found much favour with the Bank (see ECBMonthly Bulletinfor August 2005).17

The European Parliaments rapporteur on the Pact, an eminent Greek banker andpolitician, presciently reassured other Members of the Parliaments Economic and


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These two criticisms are, of course, somewhat contradictory.Either the currency union has been badly damaged by theloosening of fiscal discipline; or it has been liberated from astifling fiscal straightjacket.

The actual position is that five countries are currently subjectto the excessive deficits procedure; but only Greece (at justover 6% in 2004) is more than marginally above the 3% level.Indeed, the French Finance Minister in 2003, Francis Mer,observed at the time that the disagreement involved sums thatwere probably smaller than the margin of error in the

measuring of the deficits themselves

18

.Budget balance and Public Debt, as % of GDP, 2004

Country Budget suplus (+)/def icit(-) Public debt

Belgium 0.0 96.2

Germany - 3.7 66.4

Greece - 6.6 109.3

Spain - 0.1 46.9

France - 3.7 65.1

Ireland + 1.4 29.8

Italy - 3.2 106.5

Luxembourg - 1.2 6.6

Netherlands - 2.1 53.1

Austria - 1.0 64.3

Portugal - 3.0 59.4

Finland +2.1 45.1

area - 2.7 70.2Source: ECB Bulletin, February 2006

Monetary Affairs Committee on this point in 1996: Dont worry. When it comes to itthey wont be made to pay.18

Article in theFinancial Timesof December 11, 2003.


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The government deficit ratio in the Euro area as a whole in2004 was 2.7%. Overall Euro area public debt stands at justover 70% of GDP, whereas the target is 60%. But fivecountries are below that level, and another four not much

higher. Only Greece and Italy have levels above 100%.What really matters in practice in the words of the Treatyitself is the sustainability of the government financialposition. The best indicators of this are the yield spreads ondifferent long-term government bonds (German bonds are the

benchmark). When exchange risks ended in 1999, all spreads

were narrow. In early 2005 those for Greece, Italy andPortugal widened, reflecting their budgetary imbalances; buthave since narrowed. In other cases the spreads are negligible.

A further indicator of sustainability is the proportion ofoutstanding debt that is long-term: a need to borrow at shortmaturities is a sure sign that a government is in trouble. Butlong-term debt now accounts for 91.6% of the Euro-area total.

In reality, therefore, a fiscal doomsday for the Euro area isremote. In the case of the Pact, it can be argued, sensible

pragmatism has prevailed though the European Central Bankmay be right in maintaining that governments should be moreready to run budget surpluses in good times in order to preparefor the bad, as advised in the Old Testament Book of Exodus.

2. I nterest Rates and Convergence

One of the most frequent charges levelled at the Euro area isthat one size fits all interest rates do not work. If nominalinterest rates are uniform, but inflation rates vary in differentregions, real interest rates will also vary. The one sizenominal rates may be too low for countries with relativelyhigh inflation (e.g. Spain), and too high for countries wherethere is a risk of deflation (e.g. Germany).


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In 2002, for example the realECB minimum bid rate (nominal3.25%) was 2.15% in Germany, but only 0.15% in Spain.

The counter-argument has been that EMU in itself promotesconvergence. As markets for goods and services and

production factors integrate, inflation differentials shouldshrink and economic cycles align. What initially appear to belong-term structural differences like the preference forvariable-rate mortgages in the UK will erode as behaviour

patterns adapt to new conditions19.

Chart 1: Annual Inflation (%)

0

1

2

3

4

5

6

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

zone

BE

DE

GR

ES

FR

IR

IT

LU

NL

AU

PO

FI

Source: Eurostat

How far has convergence actually occurred? Inflation rates inthe Euro area countries since 1996 (see Chart 1) show a mixed

19

The so-called Lucas Critique of economic projections based on extrapolation from thepast. See Lucas, R.E. Jr. (1976) Econometric policy evaluation: a critique, Carnegie-Rochester Conference series on Public Policy, 1,North Holland, Amsterdam.


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picture. Excluding the latecomer Greece, they convergedduring the period of qualification for EMU up to 1998. Theythen diverged sharply, before re-converging after 2002.

In conditions of free trade in goods, inflation differentials are

usually associated with the so-called Balassa-Samuelsoneffect. Countries with a relatively low standard of livingexperience higher inflation as they catch up, a result ofdiffering productivity changes in tradable and non-tradablesectors. This, indeed, has been happening.

Are inflation rates converging sufficiently? A number of

studies have shown that price differentials within the Euroarea are already roughly the same as in the United States.Moreover, as further progress is made in creating the EUSingle Market (see next section), living standards shouldconverge, and with them inflation rates.

3. Trade, Growth and Structural Reform

Perhaps the most serious criticism of the Euro area, however,is that the creation of a Single Currency has failed to stimulateeconomic growth, and has therefore perpetuated relativelyhigh levels of unemployment. The removal of exchange risks,reduced transaction costs and a new price transparency, it had

been hoped, would increase trade and internal competition,

adding to the stimulus of a barrier-free Single Market.The Single Currency has certainly had the forecast effect20ofincreasing trade between Euro area countries, which rose byup to 20% relative to GDP in the period 1998-2001. Judging

20 See The Potential Effect of EMU entry on British Trade by Andrew K. Rose in

Submissions on EMU from leading academics (HM Treasury, September 2002). This

surveyed 24 studies on the effects of currency union, concluding that it is associatedwith an approximate doubling of trade. Other studies (for example, Fielding and ShieldsinEconomica, November 2005) have confirmed the findings.


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by the stock markets, business is also far from stagnating.Following a rise in 2003, the Dow Jones EURO STOXX indexregistered a further gain of around 10% in 2004. The ECBsReport for the year attributes this to lower long-term interest

rates, strong growth of earnings and dividends and asubstantial decline in stock market volatility, which suggestedreduced uncertainty among market participants.

Chart 2: Annual % GDP Growth (* forecast)

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

2000 2001 2002 2003 2004 2005 2006* 2007*

area UK EU25

Source: Eurostat

Yet the economic growth statistics look poor (see Chart 2).Euro area growth fell from an annual rate of just below 4% in2000 to 0.6% in 2003, then recovering to only around 2.5% in2004 and with a slight decline in 2005. Forecasts for 2006 and2007 indicate only a modest recovery.

It is worth, however, looking at the details (see Chart 3). FiveEuro area countries (Ireland, Greece, Luxembourg, Finlandand Spain) achieved overall growth rates higher than those of


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the UK. All countries experienced a sharp slow-down in2001-3; but the Euro area average was badly affected by the

performance of the largest economy, Germany. This isgenerally attributed to three factors:

0

1

2

3

4

5

6

BE DE GR ES FR IR IT LU NL AU PO FI area UK

Chart 3: Average annual % growth 2000-5

1. Thelegacy of reunification. The old East German markwas exchanged at par for D-Marks. The result was to

make the new Lnder uncompetitive, placing a largefinancial burden on the rest of Germany.

2. The conversion rate of the D-Markinto Euros in 1999.At nearly 2 D-Marks to the Euro, this was the centralERM rate when the decision was taken, but mostcommentators consider this to have been an over-

valuation. The German economy has been obliged torestore competitivity though comparatively low inflation,with the penalty of low growth and high unemployment.


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3. The reluctance of German governments like those ofother Euro area countries to carry out structuralreforms(especially the reform of labour markets).

All three explanations carry weight. It is worth noting,

however, that only the second can be directly attributed toEMU. The others have arisen from domestic political choices.The painful process of adjustment whether deliberate or not has also started to bear fruit in the success of Germanexporting and the more recent recovery of economic growth.

Many commentators also tend to underestimate the extent to

which labour market reforms are already taking place. TheEuropean Central Bank notes in its 2004 Annual Report that

over recent years a number of countries haveimplemented reforms in their tax and benefit systems in

order to reduce non-wage labour costs and encouragelabour supply. Most EU Member States introduced further

labour market reforms in 2004, including the continuedreform of income tax systems, the restructuring of socialsecurity and benefit systems, and policies to increase the

average retirement age.

However, in the context of the Euro area, structural reformmust also refer to the mobility of economic factors between

economies; and here some criticism is justified. The SingleMarket in goods has made substantial progress as result of the1992 reforms, but in other sectors there is still some way togo. Compromises have been made in implementing theFinancial Services Action Plan which limit the mobility ofcapital. The general opening up of markets in other services isonly just being partially unblocked. In the case of labour,

intra-country mobility is restricted not just by linguistic and


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cultural factors, but also by institutional rigidities: e.g. in thefield of pensions.

These criticisms, however, refer to the EU in general ratherthan the Euro area in particular. Thebarriers need to be

removed in any case if there is to be a real Single Market.

4. Unemployment

The average rate of unemployment in the Euro area has nowremained above 8% for several years, despite all the efforts ofnational governments for example, the 35-hour week inFrance to get the figures down. It can even be argued that,

given the reported rigidities in the labour and service markets,this is the natural rate for the area consistent with stableinflation (i.e. the euro areas NAIRU21). Unfavourablecomparisons are made with rates around or below 5% in theUS and the UK.

The unemployment figures on their own, however, can be

deceptive. If they are taken in conjunction with theemployment figures, a different picture emerges. As theEconomist22 has observed, employment in the Euro area hasbeen rising much faster than unemployment has been fallingas reforms have dragged previously discouraged workersinto the labour market.

Moreover, the main reason for the USs trend growth rate ofaround 3%, as opposed to the Euro areas 1.8%, has been afaster increase in the US population. Growth of GDP per headhas been more or less the same (US 1.5%, Euro area 1.4%).

Ah, but America is better at creating jobs, isnt it?Actually, no. Employment has grown a tad faster in the

21 The Non-Accelerating-Inflation Rate of Unemployment.22

November 19th25

th. 2005.


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euro area than in America a striking improvement onthe decade to the mid-1990s..

The Economist finally observes that the Euro area hasachieved this growth, unlike the US, without huge increases in

the current account and budget deficits; so its record is moresustainable than Americas.

Politics and Perception

All EU governments are tempted to blame Europe fordifficulties of their own making. Electorates generally havelittle idea how EU decisions are taken, and are only too willingto believe that there is a vast, unelected Eurocracy in Brussels,imposing absurd regulations out of the blue. Kaletsky hasobserved that

in the Netherlands, France and Germany, the euro has

started to be blamed for inflation, economic instability and

unemployment, while admitting that some of these

charges may not be intellectually sustainable23.

Blaming the ECB is easier than admitting failure to open upEU markets or to carry out painful domestic reforms.

Following the introduction of -denominated notes and coins,there was an outcry in Euro-area countries that this had led to

price increases in Germany, the Euro was dubbed the

Teuro24. Throughout the Euro area, 83% of people thoughtthat the conversion into Euros had resulted in a generalrounding-up of prices25; and, indeed, there was evidence thatcafs, restaurants and other service industries had used the

23 The Times, Thursday August 25, 2005.

24The German teuer means dear.25

Eurostat, May 2002.


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introduction of new and unfamiliar notes and coins to disguiseincreased profit-margins.

Yet, when the actual inflation figures were published, theyindicated that the changeover had had virtually no overall

effect on prices. The explanation lay in the difference betweenactual and perceived inflation. The prices of goods boughtfrequently for example, cups of coffee had been roundedup, often by 10% or more. The prices of goods bought lessfrequently clothes, consumer durables, cars had fallen as aresult of increased in intra-Euro-area competition. The public,

however, had perceived only the changes in the former items.In Italy, the problem was compounded by the shift from asingle unit, the Lira, to a two-tier system of Euros and Cents.

The situation in Italy is also instructive for another reason. Thesubstitution of the Euro for the Lira brought a massive gain forthe Italian economy: the sharp reduction in interest rates cut, ata stroke, the burden of interest payments on outstanding publicdebt. This was a significant factor in enabling Italy to meet thefiscal conditions for Euro area membership. Now, however,the Euro has been getting the blame for low growth andunemployment. There has even been some wild talk ofwithdrawing from the area and re-creating the Lira.

What Italians are missing, of course, is the freedom to

devalue. But depreciation of the Lira was the main reason forhigh pre-Euro interest rates. A return to the old policy wouldhave immediate, substantially adverse fiscal effects, as well asruining Italys international credit rating. Fortunately for Italy,the markets do not believe that anything like this will happen.

It is also worth noting that there are likely to be long-term

penalties for being outsidethe Euro area but insidethe SingleMarket. In the absence of other trade barriers, companies


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wishing to supply the market as a whole will prefer to locatewherethere is least currency risk (i.e. in the Euro area) ratherthan in a peripheral economy. This applies both to internalinvestment and to inward investment from outside the EU.

The UK and the Euro

Judged by the criteria of economic growth, unemployment,inflation and until recently fiscal sustainability, the UKhas outperformed the Euro area ever since 1999. Why, then,should we adopt the Euro? Were doing OKwithout!

The first problem with this argument is that other statistics canbe cited pointing in the opposite direction: for example,productivity (GDP per hour worked26), where the UK doesworse than every Euro area country except Greece, Portugaland Spain. The UK is running a trade deficit (goods andservices) equal to -2.4% of GDP, whereas the Euro area has

been running annual surpluses of around +0.2% of GDP.

According to the OECD, in 2005 the UK will have had abudget deficit (-3.1 of GDP) worse than the Euro areas. In2006 UK inflation will also be higher, and the Euro area mayeven have a higher rate of economic growth.

In addition, the argument implies that adopting the Euro wouldbe more attractive if the Euro area were outperforming the

UK. This would be quite the wrong basis for membership. Asthe UK Treasury has elaborated in its massive study of theissues, UK entry should be based on a careful cost/benefitanalysis, irrespective of who seems to be doing better at thetime. The statistics behind the arguments, moreover, arealways in flux, so that even the most thorough assessment canrapidly get out of date. One such study by opponents of UK

26 OECD figures, December 2004


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membership wisely states that the nocampaign does not saynever to the euro27.

An important factor will be the likely expansion of the Euroarea to include more EU Member States. At present, the EU is

more or less equally divided between countries using the Euroand countries retaining national currencies. However, the tennew Member States have no opt-outs, nor did they request anyduring the accession negotiations. They are required by theTreaty to adopt the Euro on fulfilling the convergence criteria.Already the currencies of seven28 have joined the Danish

kronein the Exchange Rate Mechanism (ERM2): the first stepin becoming full members of the Euro area.

By around 2011, therefore, it is likely that a large majority ofMember States will be in the area, even allowing for furtherexpansion of the EU to cover Romania, Bulgaria and perhapsone or two others. The simple business argument for joining that, in tendering for a contract in the Euro area, a firm basedwithin it, having no exchange risk, enjoys a cost advantageover a firm which is not will carry more weight.

It will also increase the weight of the Euro Group (the onceinformal, but now formalised meetings of Euro area FinanceMinisters29) in decision-making within the EU as a whole. Atthe same time, the international role of the Euro is also likely

to have expanded. This will change the international monetaryenvironment in which Sterling operates.

27The economic case against the euro, New Europe Research Trust, 2001.

28 The Estonian kroon, the Cyprus pound, the Latvian lats, the Lithuanian litas, the

Maltese lira, the Slovak korunaand the Slovenian tolar.29

The Euro Group has tended to meet before the Finance Ministers of the EU as a whole(ECOFIN), and there are reasons to believe that many major decisions have beeninformally agreed by the Group in advance of ECOFIN discussions.


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International developments are, indeed, crucial. Part of thecase against Britain joining the Euro area rests on the pastvolatility of the /$ exchange rate, given the pattern of ourtrade. An inveterate opponent of joining, Professor Patrick

Minford, has observed that if Britain joins the Euro areawe thereby increase our exchange risk against the dollaras the euro swings around against it. If we remain outside,

the pound cango between the two, rather like someonesitting on the middle of a seesaw.30.

But the volatility seen immediately after the Euros creation

will not necessarily continue, still less the volatility of the D-Mark against the Dollar from 1980-99 which Prof. Minfordincludes in his calculations. It has, in any case, been pointedout that the argument contains

an elementary error. If all EU countries had used onecurrency (the DM) since 1985, our trade-weighted

exchange rate would have been much less volatile thanwas in fact the case the coefficient of variation of itsmonthly value would have been 4% rather than 8%.31

Indeed, the Pound has recently been quite stable against theEuro much more so than against the Dollar.

Finally, it is by m no means certain that the Fed and the ECB

will always conduct policies of benign neglect towards theirexchange rates. Discussions continue within the IMF and inother contexts for the creation of a new international financialarchitecture, within which the Dollar and the Euro might belinked (as indeed advocated by Mundell)32.

30Prof. P. Minford, Should Britain Join the Euro?,Institute of Economic Affairs, 2002.

31Why Britain should join the euro, Britain in Europe, October 2002.32

Does the $/ rate need to be managed?, Lecture in Luxembourg, 8 March 2000.


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Conclusions

When I first learned of the intention of the 1988 Hanoversummit to set European monetary union in motion,Financial Timescommentator Martin Wolf wrote in 1998,

I thought it insanely risky. I still think it risky. But it nolonger looks insane.33

This personal observation accurately mirrored British opinionat the time. Since then the Euro has been introduced efficientlyand on time; has weathered the fall of its parity against theDollar between 1999 and 2001; and has now established itself

as a stable currency, internally and on international markets.It is true that, measured against many optimistic predictionsduring the 1990s, the effects of EMU in promoting economicgrowth and employment have disappointed. A more relevant

benchmark, however, is the probable situation had the chaoticfinancial environment of that period continued. It is worth

remembering that powerful voices were then arguing thatmobility of capital within the Single Market andinternationally had resulted in dangerous instability, and thatthere would have to be a return to exchange controls. If thewhole process of freeing up European and world markets hadthen been put into reverse, the cost in terms of lost growth and

jobs would have been huge.

Of course, the successful creation of the Euro area has notprevented critics from forecasting its eventual demise.Historians have observed that past experiments with currencyunions have generally lasted only when accompanied by

political union (e.g. 19th. Century Germany); and have tendedto dissolve when the political framework has broken down

33Financial Times, May 5, 1998.


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(e.g. the Soviet Union). Many, both supporters and opponentsof European integration, have therefore concluded that EMUcan only survive if the Treaty objective of ever-closer unionis vigorously pursued. For some, this has indeed been the

purpose of the exercise in 1950 the French economistJacques Rueff famously stated that lEurope se fera par lamonnaie, ou ne se fera pas34.

A study of history also shows, however, that the one-to-onelink between currencies and nation-states is a fairly recent

development35; and that political union sometimes precedes

monetary union, and sometimes follows; but not always.It is also arguable that the apparent past dependence of acurrency on its political framework has been mainly due to thepoliticisation of money by governments, and what AdamSmith called the avarice and injustice of princes andsovereign states36. Where money has been in some measureautonomous or international for example, has taken the formof gold the system has worked satisfactorily in spite ofchanges in national political environments (see the quotationfrom Milton Friedman in the Box on page 6). The modernequivalent is the independence of Central Banks. Even if

political union in Europe goes no further than at present asseems likely there is no reason why the Euro should not

continue to flourish as a, literally, inter-national currency.Sceptics often raise the spectre of a slide towards economicgovernment from Brussels and the harmonisation of taxation,

34 SeeLAge de lInflation, Paris: Payot, 1963.35

Christopher Johnson,In with the Euro, out with the Pound, Penguin 1996.36

The Wealth of Nations, Book 1, Chapter 4: Of the Origin and Use of Money. AdamSmith was noting the tendency for governments to renege on their debts throughdebasement of the currency, so abusing the confidence of their subjects.


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citing as evidence the opinions of, many French politicianswho want to do just that. It should be noted, however, thatsuch opinions arise because those holding them both dislikethe independence of unelected Central Banks, and fear

competition from countries with more efficient tax systems.What they advocate is neither inherent in EMU, nor inevitable.

In the end, the success or failure of the Euro is likely todepend on how far the Euro area economies converge. But, asthe UK Treasury observes, it is not necessary to have

complete convergence at all times. That would be an

impossible standard, and one not met in existing andsuccessful monetary unions37.

Inflation rates areslowly converging as economies with lowerprevious standards of living catch up (see Chart 1), though thisprocess will inevitably be prolonged as the countries ofCentral and Eastern Europe join the system.

In the case of economic growth (which the UK Treasury notesis used widely as a basic indicator of cyclicalconvergence38) detailed analysis in the ECBs May Bulletinshows that significant convergence has also been taking place(see Chart B). The ECB nevertheless goes on to point out that

therehave been enduring differences in growth between

euro area countries. As these differences largely appear toreflect structural factors, they must be addressed byappropriate national measures.

The factors which will determine the fate of the Euro area,therefore, are much the same as those which will determine

37

UK membership of the single currency: an assessment of the five economic tests,June 2003, p.27.38

ibid. p. 29


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the fate of the EU economy as a whole. The necessary policiesare also the same: completing the Single Market, particularlyin the services sectors; and renewed progress in fulfilling theLisbon Agenda to make the EU at least one of the most

competitive economic areas within in the global economy.

Source: ECB Monthly Bulletin, May 2005

Finally, there is the special position of the UK. It is important

to remember that, by opting out of Euro area membership, theUK has not thereby opted out of the Euro areas success orfailure. On the contrary the UK has an urgent interest inseeing that the currency area forming its most importanttrading partner prospers.

In consequence, the need to be at the heart of Europe

pressing for policies to strengthen both the EU, and within itthe Euro area, remains a no-brainer for any UK government.


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Ben Patterson

Ben Patterson was the Member of the European Parliament forKent West between 1979 and 1994, and Vice-Chairman of its

Economic and Monetary Affairs Committee between 1992 and1994. From 1974 to 1979 he was Deputy Head of theEuropean Parliaments London Information Office; and from1994 to 2004 worked in Luxembourg for the ParliamentsResearch Directorate, during which period he was also amember of the Parliaments Monetary Union Task Force. Hecurrently sits on the European Movements policy committee.

Some recent European Movement publications

MEPs, the Europeean Parliament and Public Opinionby Michael Barry

Regulation by Brussels? The Myths and the Challengesby David Stephen

Insular by Default? How the BBC presents Europe to the British Public by

Martyn BondRelegated to the Second Division? Why Associate Membership of the EU

would be bad for Britainby Diana Wallis MEP

Britain in EU Decision-makingby Richard Corbett MEP

7 Graphite Square, Vauxhall Walk,London SE11 5EE

Telephone: +44(0)20-7820-9965

e-mail: [email protected] page: http://www euromove org uk/
http://www.euromove.org.uk/http://www.euromove.org.uk/http://www.euromove.org.uk/http://www.euromove.org.uk/

The Euro - Success or Failure.docx

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