The Euro

– A Patient? Essay, Research Paper

The Euro A Patient?

It was the horror and devastation of the Second World War which gave the impetus to move towards unity in Western Europe. However, there were and remain divergent views on how this should be achieved, to what extent it should be achieved and by when it should be achieved. Rodney Leach has stated that since World War 2, there have been two contrasting visions of Europe s destiny, one of which has come to predominate. It could be said that the European Union today is a would-be federation at least halfway towards its goal. The movement can only be forward because of its ratchet structure, an effect derived from acquis communautaire the doctrine that each step towards integration is irreversible (also stemming from the Treaty of Rome s paramount aim of even closer union). The rival vision of Europe was of allies voluntarily co-operating with only the absolutely necessary common laws. It is federalism which has won the upper hand.

The establishment of a single currency is obviously a vital step if the goal of federation is to be achieved. There still remains dispute on what federation actually means. The goal for many is total economic and political union.

As far back as 1970, the Council of Ministers began to prepare plans for full economic and monetary union. It appears to have given no consideration to the pros and cons of monetary unions. The Council only looked at the routes to achieve monetary union. The routes chosen involved as John Mills writes an uneasy marriage of Keynesian and monetarist approaches .

It is this which helps to explain some of the difficulties which have arisen with the implementation of the Euro. The Keynesian economists believed that there should be convergence of economic performance and policies among member states, with monetary union to follow when these conditions had been established. The monetarists believed that the best way forward was to establish monetary union immediately on the grounds that this would create the necessary economic convergence. In the event, the compromise was to achieve some convergence of economic performance and then to have the full rigour of monetary union.

Early efforts involved the Snake, the Snake In The Tunnel and the Exchange Rate Mechanism (which eventually had 15% wide fluctuation bands). The Maastricht Treaty of 1991 obliged all countries intending to enter into a single currency to meet convergence criteria. However, by 1998 the criteria (which related to inflation rates, interest rates, budget deficits, national debt and exchange rates) were being fudged and were being interpreted to suit particular circumstances of individual member states, John Mills goes as far as to indicate that some European economists believed that entry into the single currency was built on a foundation of false statistics and unsustainable trends. Furthermore, it must be noted that the criteria were solely related to financial variables and none of them to economic policies such as growth, full employment, and inflation at an acceptable (as opposed to the lowest possible) level. This danger had been pointed out by Keynesian economists in the early 1970 s. Possibly only Luxembourg truthfully matched the Maastricht criteria at the entry date of January 1st 1999. It is this that was in part the cause of the difficulties in which the single currency has found itself.

The entry was greeted by celebration, self-congratulation and talk of a new era for economic and social advancement. But almost immediately problems arose. The euro s value plummeted week by week. At the end of the first hundred days the euro had lost 10% of its value against the dollar. Julian Coman at this time quoted a European Commission official as saying, we are not all converts. Frankly, one looks at the British economy, which is in the best state anyone can remember and has just worked out its own arrangements with its own independent central bank, and one wonders whether they are better off to stay out .

At this time there were those who said that part of the cause of the euro losing its value was because it was entangled with the economic problems of Germany.

There were signs in 1999 that Europe s economies far from converging were actually diverging and this was giving great concern to the supporters of the single currency. The question could be asked if it really matters if there is divergence. Jiten Borkakoti examines the lack of convergence in the economies of the Canadian provinces and the states of the USA where there were real exchange rate differences comparable to the EU. Borkakoti points out that political union preceded monetary union in many previous monetary unions e.g. Germany in 1871. On this basis the drive to political union could become stronger. Borkakoti is pointing out that lack of economic convergence does not inhibit overall economic growth.

In fact by March 1999 the Organisation for Economic Cooperation and Development had, with no exchange rate option available to counter economic structural difficulties, suggested that other solutions, such as the mass migration of workers, would have to be found to solve the region s chronic unemployment rate of about 12%.

However the OECD agreed that Europeans would not move between countries as Americans move states and neither would Brussels ever be trusted with the kind of budget that Washington has to level out regional equalities (unless there was political union!).

At this early stage of the euro with investors (and speculators) having no faith in overall economic performance and the strong expectation of a further fall in value, there was almost a self-fulfilling prophecy.

Disputes among member states were arising. The German economy was stagnating if not contracting, and attempts by Lafontaine to obtain interest rate reductions to counter German deflation were blocked by Wim Duisenburg and the ECB. At this time there were also disputes over the Common Agricultural Policy and regional subsidies.

The euro continued to remain at low levels on the foreign exchange markets over the next year. There was pressure on the ECB to raise interest rates which would attract inward investment and raise the value of the euro. The ECB base rate rise from 3% to 3.25% in February 2000 did increase the exchange rate against the dollar to 99 cents but it soon began to fall again. The worry was that a low exchange rate for the euro would fuel inflation by making imported goods more expensive. Foreign exchange traders still had no confidence in the long-term stability of the euro but economists were warning the ECB that raising the rate of interest to counter traders dealings would be dangerous.

Stefan Schneider referring to this possibility said that if they develop a Pavlovian response pattern, the marker might start to speculate on that and it could evolve into a case of the market pushing the ECB into action and not the other way round .

Bankers estimated that every 10% loss in Euro value increases inflation by as much as 0.5% points . Nevertheless, the low value of the euro was helping exports from euro countries and assisting a very slow economic recovery. However, investors were still preferring the USA and Petra Koehler , an economist with the Dresdner Bank, concluded at this time that the struggling euro is more a sign of the strength of the US economy rather than a weakness of the European economy .

In early September 2000 Wim Duisenburg stated that the slump in value of the euro was of great concern especially for inflation control. He did not rule out intervention (e.g. using dollar reserves to buy euros). By September 12th 2000, the value of the euro had fallen to 85.50 cents (a decline of 27% from the starting value of $1.17 of June 4th 1999) and there were calls for Duisenburg s resignation. But he insisted that the euro had been successful the currency had secured price stability and removed exchange rate variations within the eurozone.

Duisenburg really blamed financial factors and international money movement for the predicament of the euro, but to return to the point of underlying economic structures it might be argued that the opportunity for economic growth was greater outside the eurozone due to more flexible labour markets and lower levels of business taxation.

By the end of September 2000 the ECB was urging governments within the eurozone to carry out structural reforms to improve economic productivity and efficiency. Philip Thornton quotes ECB sources as saying the prospects for stronger potential growth in the euro area and for the external value of the euro will depend very much on whether progress is made along these lines . We find the ECB saying in reply to criticism by the IMF over lack of intervention to prop up the euro that the decline in the exchange rate of the euro contrasts more and more with economic fundamentals . The bank also emphasised oil price rises as contributing to inflation and warned of the dangers of wage inflation.

By early November 2000, European central bankers intervened in the money market, buying euros to boost the euro exchange rates. By the end of the year the euro started to recover amidst fears that the US economy might be heading for a downturn. The US government had revised down GDP growth. There was also in the USA a small fall in personal incomes and a rise in unemployment claims. Michael Lewis , a currency economist at the Deutsche Bank, went as far as to say that people feel that the euro s time is now upon us . The euro rose to 89 cents. However, David Bloom , a global economist with HSBC, said, the euro is going up but the bottom line is that the US is deteriorating rather than the euro improving. This is more dollar doldrums than euro euphoria .

Certainly the eurozone entered 2001 with greatly improved confidence. Predictions of strong economic growth in the zone s biggest economies Germany, France and Italy coinciding with a slowing of growth in the USA suggested a continued revival for the euro. The euro finished 2000 at 94.20 cents and Gerhard Schr der , the German Chancellor claimed that those who has said that Germany s highly regulated social economy was the cause of the euro s sickly performance had been proved wrong. Some senior figures in the German government were more concerned that the euro might rise too high and choke off exports and so push the unemployment rate.

This really is an astonishing turnaround. The sickly patient referred to by Schr der seems to be well on the way to recovery. However, it is still important to remember that the euro is still well below its January 1999 value. At the time of writing (Friday 9th March 2001) the euro is valued at 93.2 US cents as opposed to $1.17 when it was floated down by over 20%.

So why did the euro become a patient in need of treatment? It might firstly be asked if the euro was overvalued in the first place. Speculation against the high value drove the value down. However, there were probably underlying structural problems. The European economies were not in line with each other. There were disputes over what should be the level of interest rates. This led to a lack in the confidence of international investors that the eurozone could achieve reasonable growth and so reasonable returns on investment. The US economy meanwhile was continuing to boom and prospects for growth were good. While the UK did not do well against the USA, it certainly performed well against the euro and the pound was strong against all eurozone currencies (but causing problems for UK exporters). There is the point of lack of flexibility in eurozone economies, particularly Germany. Schr der denied that this had any effect but in terms of growth it probably did.

Confidence does seem to have returned at international level but I don t think we can say that the euro is now totally well and not in need of care. There will need to be a need to ensure a sound economic infrastructure which will make eurozone industry internationally competitive at higher euro-exchange rates. Also the base interest rate of the ECB is 4.75%, below the 5.5% of the USA and 5.75% of Britain (9/3/01) which is still probably having some effect on inward investment. Confidence hasn t totally returned. Switzerland has voted against entry, Ireland is running economic policies which the ECB feels are inflationary. On a public opinion base a recent Guardian poll showed 62% of British voters opposed to joining the euro. Only 29% of German voters are now satisfied that the euro has replaced the German national currency. Support in France has dropped by 14 points to 50% while in Spain, Greece and Italy 46% or fewer are now satisfied with the change from their national currencies. Only in Luxembourg was there a high percentage in favour of the decision to join the euro.

The euro is probably out of danger, convalescing, but still not looking fully fit in many people s eyes.

Bibliography

Books

Leach, R. Europe (London: Profile Books, 1998)

Mills, J. Europe s Economic Dilemma (Basingstoke: Macmillan, 1998)

Borkakoti, J. European Union at the Crossroads ed. C.C. Paraskevopaulos (Cheltenham: Elgar 1998)

Gros, D. & Thygesen, N. European Monetary Integration (Harlow: Longman 1992)

Dyson, K. The Politics of the Euro-Zone (Oxford: Oxford University 2000)

Barrell, R. Economic Convergence and Monetary Union in Europe (London: Sage 1992)

Articles

Coman, J. They d rather forget the euro s first 100 days in The Daily Telegraph (London: 4 April 1999)

Greimal, H. Sliding Euro worries bank in the Independent (London: March 2 2000)

Thornton, P. ECB urges eurozone member to cut back on spending in The Independent (London: 22 September 2000)

Thornton P. Euro stages comeback on fears US and Japan are heading for recession in The Independent, (London: 5 December 2000)

Helm,T. Euro-zone starts year in mood of confidence in Daily Telegraph, (London: 2 January 2001)