The euro is the result of the most significant monetary reform in Europe since the Roman Empire. Although the euro can be seen simply as a mechanism for perfecting the Single European Market, facilitating free trade among the members of the Euro-zone, it is also regarded by its founders as a key part of the project of European political integration.
The euro is administered by the European System of Central Banks (ESCB), composed of the European Central Bank (ECB) and the Euro-zone central banks operating in member states. The ECB (headquartered in Frankfurt am Main, Germany) has sole authority to set monetary policy; the other members of the ESCB participate in the printing, minting and distribution of notes and coins, and the operation of the Euro-zone payment system.
The introduction of a single currency for many separate countries presents a number of advantages and disadvantages for the participating nations.
1. Removal of Exchange Rate Risk
One of the most important benefits of the euro will be lowered exchange rate risks, which will make it easier to invest across borders. The risks of changes in the value of respective currencies have always made it risky for companies or individuals to invest or even import/export outside their own currency zone. Profits could be quickly eliminated as a result of exchange rate fluctuations. As a result, most investors and importers/exporters have to either accept the risk or “hedge” their bets, resulting in further costs on the financial markets. Consequently, it is less appealing to invest outside one’s own currency zone. The Euro-zone greatly increases the potentially “exchange-risk free” investment area. Since Europe’s economy is heavily dependent on intra-European exports, the benefits of this effect can hardly be overstated. This is particularly important for countries whose currencies have traditionally fluctuated a great deal such as the Mediterranean nations.
2. Removal of Conversion Fees
A benefit is the removal of bank transaction charges that previously were a cost to both individuals and businesses when exchanging from one national currency to another. Although not an enormous cost, multiplied thousands of times, the savings add up across the entire economy.
3. Deeper Financial Markets
Another significant advantage of switching to the euro is the creation of deeper financial markets. Financial markets on the continent are expected to be far more liquid and flexible than they were in the past. There will be more competition for and availability of financial products across the union. This will reduce the financial servicing costs to businesses and possibly even individual consumers across the continent. The costs associated with national debt will also decrease. It is expected that the broader, deeper markets will lead to increased stock market capitalization and investment. Larger, more internationally competitive financial and business institutions may arise.
4. Price Parity
Another effect of the common European currency is that differences in prices – in particular in price levels – should decrease. Differences in prices can trigger arbitrage, e.g. artificial trade in a commodity between countries purely to exploit the price differential, which will tend to equalise prices across the euro area. This should also result in increased competition between companies, which should help to contain inflation and which therefore will be beneficial to consumers. Similarly, price transparency across borders should benefit consumers find lower cost goods or services.
5. Macroeconomic Stability
An important side-effect of the euro will be greater macroeconomic stability for the entire continent. Much of Europe has been susceptible to economic problems such as inflation throughout the last 50 years. Inflation is a very damaging phenomenon from most of society’s perspective. It discourages investment, can cause social unrest, and causes problems for taxation. However, many countries are unable or unwilling to deal with serious inflationary pressures. They often have other priorities that compromise their ability to deal with inflation. Sometimes their economic clout is simply insufficient. However, there have been models, particularly with largely independent central banks, that have successfully countered inflation. One such bank was the Bundesbank in Germany; since the European Central Bank is modeled off of the Bundesbank, is independent of the pressures of national governments, and has a mandate to keep inflationary pressures low. Many economists foresee a period of increasing price stability in Europe after the euro’s introduction.
6. Less-specific Monetary Policy
Some economists are concerned about the possible dangers of adopting a single currency for a large and diverse area. Because the Euro-zone has a single monetary policy, and so a single interest rate, set by the ECB, it cannot be fine-tuned for the economic situation in each individual country (however, prior to the introduction of the euro, exchange rates were already very much in sync after the European currency crisis in the early 1990s). Public investment and fiscal policy in each country is thus the only way in which government-led economic stimulus can be introduced specific to each region or nation. This inflexible interest rate might stifle growth in some areas, while over-promoting it in others. The result could be extended periods of economic depression in some areas of the continent, disadvantaged by the central interest rate. Given such a situation resentment and friction within the community, and toward the bank, might well increase. Others point out that in today’s globalized economy individual countries do not have power to effectively manage their monetary policy, as it creates other imbalances. This effect was already visible in the European currency crises of 1992, when the Bundesbank was effectively coordinating monetary policy for the whole continent.
Euro Vs Dollar
Some proponents of the euro point out that the Euro-zone is similar in size and population to the United States, which has a single currency and a single monetary policy set by the Federal Reserve. However, the individual states that make up the USA have less regional autonomy and a more homogeneous economy than the nations of the EU.
If the euro were to become either a hegemonic currency replacing the dollar or a cohegemonic currency equal in reserve status to the dollar, some of the subsidy the USA gains would be transferred to the EU and help balance out some of the problems of the present heterogeneous economic structure still in place.
The euro will probably become one of two, or perhaps three, major global reserve currencies. Currently, international currency exchange is dominated by the American dollar. The dollar is used by banks as a stable reserve on which to ensure their liquidity and international transactions and investments are often made in dollars.
What makes a currency attractive for foreign transactions? Primarily, a proven track record of stability, a broad, well developed financial market to dispose of the currency in, and proven acceptability to others. The Euro will almost certainly be able to match these criteria at least as well as the U.S. dollar, so given some time to become accepted, it will likely begin to take its place alongside the dollar as one of the world’s major international currencies. There are several benefits to reserve currencies of being such an internationally acceptable currency. If the euro were to become a reserve currency it would benefit member countries by lowering the service charges on their debts. Since the currency would be so broadly acceptable it would make the premiums paid to debt holders lower, since the risk to the borrower is lower.
Credit: International Economics-CU