The Costs and Benefits of Joining EMU - Case Study Example

The Costs and Benefits of Joining EMU Introduction The introduction of economic and monetary union (EMU) was aimed at realization of European integration. Although the launch of EMU has been successful, the cost of being a member of the union is greater than the benefits gained. The establishment and launch of EMU was aimed at encouraging smooth free trade within the member states. The launch of the union has been accompanied by use of common currency, as one of its objective so as to break some of trade barrier arising from use of separate national currencies (Debra, & Colin, 2007, p. 162). The EMU has also been created to increase the interdependence among the member states. The increasing interdependence among the European states is aimed at creating free mobility of goods, services, labour, and capital within the trade region (Debra, & Colin, 2007, p. 162). The EMU has increased the common rules among the member states to combine the separate markets and economies by increasing the economic coordination and cooperation, and setting new competition policies for the member states. The EMU has created economic interdependence so as to eliminate monetary polices that undermine and distort benefits realized from such interdependency (Debra, & Colin, 2007, p. 162). For the EMU to function smoothly, the following feature must be present: Policies must be harmonized to eliminate obstacles that impede free movement of factors. If the obstacles are cleared, there will be free movement of services, capital, goods, and labour Availability of many common policies in the area of macro-economic policy. Pegged foreign exchange rates to enable use of common currency. Monetary policy should be common for all member countries. This should be in policy areas such as: exchange rates, and interest rates. Reserves of foreign exchange for the European Union member countries Inter-state transfers should be possible to enable the states to counteract economic and monetary union economic distortions (Debra, & Colin, 2007, p. 163). The member states of EMU must surrender their sovereignty in some areas of policy formulation. Such areas include: interest rates and exchange rates determination, and constrains acceptance in macro-economic exercise (Debra, & Colin, 2007, p. 163). The politicians from the member states of EMU are required to undertake unpopular policies required for a state to qualify to be a member of EMU, and also introduce economic structural reforms that will ensure their country’s economies survive within the economic and monetary union. However, reluctance among the major European Union community has led to serious problems of EMU. The above feature and condition do not determine whether European Union has ideal environment for using common currency. The optimal currency areas (OCAs) theory sets the preconditions for use of common currency among states. For the EMU to succeed in using common currency, the following conditions must be fulfilled: There should be no asymmetric shocks. There should be high degree of labour movement, and flexibility in wages. There should be centralized fiscal policy to enable the transfer of resources to the affected countries (Debra, & Colin, 2007, p. 163). Though the EMU has been launched, some of these conditions appear to be lacking within the European Union trade region. However, some benefits have gained by the European Union countries for being members of EMU. Benefits of Joining Economic and Monetary Union The main perceived benefits of joining economic and monetary union include: low costs of transaction, single market consolidation, convergence of prices, stabilization of foreign exchange rates, and price stability (De Grauwe, 2005). It has been estimated that $30 billion are spend each year in trying to hedge exchange rates and in transactions involving foreign exchange. The reduction of these costs will be of great benefit to countries such as Ireland which export most of its products to the European Union markets. The small and medium enterprises will also benefit if such transaction are eliminated (Copeland, 2000, p. 265). Single market consolidation is significant in that, it makes production to be efficient because of economies of scale and increased levels of specialization. The efficiency in production in this case will result into increased gross domestic product within the European Union (Copeland, 2000, p. 265). If the economic and monetary union prevents exchange rates fluctuation, this will create certainty among the investors who invest in foreign markets. As a result of this, more foreign investors will be willing to establish business enterprise in Europe. Also, the national monetary authorities will have an opportunity to save because of reduced international reserves (Copeland, 2000, p. 266). This could also result to cut down of interest rates in Irish, thus encouraging more foreign investors, and reduce debt servicing cost which will finally lead to higher levels of national income. The elimination of risks arising from exchange rates fluctuation has positive impact on the environment for doing business at international level (De Grauwe, 2005). When investors are able to predict the exchange rates in the financial markets, it will be less risky for them to invest in foreign markets. The economic and monetary union has eliminated the exchange rate fluctuation risk (Copeland, 2000, p. 266). Use of common currency among the European Union states will help in identifying price differentials. The enhancement of competition through elimination of price differences, will result to higher economic efficiency and ultimately cause convergence in prices. This will also result to elimination of discrimination practiced in European markets. If there is no politics on the central bank, the European monetary policy will succeed in maintaining price stability under single currency in circulation (Copeland, 2000, p. 267). Integration of financial markets offers different ways in which risks can be shared in economic and monetary union. For example, suppose that the equity and bond market of German and Italy are integrated, it will be easy to facilitate the asymmetric shocks adjustment. If Italy is affected by an economic shock, the firms and companies in Italy will experience declining stock prices (De Grauwe, 2005). Since the stock market in Italy and Germany are integrated, it implies that French stocks are held by investors from Germany. If at the same time we have increase in price of stocks in Germany which are held by investors from France, the French investors will benefit from the increasing profit from Germany financial market. This has the implication that the negative effects of economic shocks are shared by all member states of economic and monetary union (De Grauwe, 2005). Costs of Joining Economic and Monetary Union Although the launch of economic and monetary union has been successful, the union has been faced by myriad challenges. The fact that the economies of European states are diversified makes it difficult for European Union states to implement the EMU objectives. Integration of economies with different efficiency levels, inflation, structures, and productivity under a single currency is the biggest challenge for the European Union (Weber, 2000, p. 4). If the economies of European Union member states had similar goals, they would have easily implemented the same policies and react to the changing situation in the same way, thus being able to get rid of several fixed exchange rates advantages (Weber, 2000, p. 5). The reason behind fixing rates of exchange at national level is because most economies are different, and it is important to have national monetary authority to respond to internal economic shocks for the purpose of efficiency gain (El-Agraa, 1994). For any country joining the economic and monetary union must be ready to incur some costs. There are two cost which are incurred under EMU: one is the individual and institutional cost necessary to readjust to the new currency, and two is cost incurred by a state due to lack of the appropriate monetary policy tool to readjust the equilibrium of economy when it is affected by an economic shock (El-Agraa, 1994). It has also been found that states incur a lot of cost in the process of making adjustments in databases, invoices, price lists, payrolls, office forms, bank accounts and postage meters (Weber, 2000, p. 4). The economic shocks which take place in economic and monetary union member states macroeconomic environment occur without any notice and thus bring imbalance in investments, production, trade, government expenditure, consumption, and production. However, due to diversity in economies among the EMU states members, the effects of economic shock are not the same. These kind of economic shocks are referred to as asymmetric shocks (El-Agraa, 1994). The impact of asymmetric economic shocks will be felt in EMU, where one economy will experience a declining economic growth while the other economies experience an increasing economic growth (Weber, 2000, p. 10). In this case, if a country had not joined the EMU it could have used national fiscal and monetary policies to handle the asymmetric economic shock. However, since the country has joined the economic and monetary union has got no right to use national monetary policy to correct the problem. For this matter, the affected country must seek other measures to correct the asymmetric economic shock (Weber, 2000, p. 10). Evaluating the Benefits and Costs of Joining EMU The fact that there are many factors hindering effective implementation of economic and monetary union objectives, the big question remains that why has the European union members went ahead to implement the project. Although the benefits and costs incurred by being a member of EMU are hard to quantify, the gained benefits are not great (Debra, & Colin, 2007, p. 169). It has been said that EMU help in saving transaction cost. However, the approximated cost saving by EMU is 0.5 percent of the gross domestic product realized from the European Union (Debra, & Colin, 2007, p. 169). In addition, these benefits tend to be unevenly spread. It has been observed that among the member states, the smaller countries which depend heavily on trade within the European Union region benefit more from the EMU (De Grauwe, 2005). The member states of EMU have been said to benefit fully from the Union after long time duration. For example, for the EMU to run smoothly there should be stability in prices which will have to stimulate higher investment levels. Since maintaining price stability within the European Union is a long term goal, implies that benefit from EMU will not be realized immediately (Debra, & Colin, 2007, p. 169). The effects of EMU on business are not equally distributed. Those business enterprises which get their revenue from foreign markets gain more from EMU. For this reason, the larger business enterprises are the one likely to benefit more from the union. The same benefits will also be felt by the large companies whose investors are not from within the European Union region (Hayo, 2003). Moreover, not all large business enterprises will gain from the EMU benefits. Enterprises that have got well established domestic market will not gain a lot of benefits until their market begin to show higher degree of international-isation (Debra, & Colin, 2007, p. 169). Although most small and micro enterprises sell their products locally, those which export their products are expected to gain from the use of common currency (Hayo, 2003). Despite the efforts that have been put to have convergence among the member states of EMU, price differentials still persist. For EMU to be successful in ensuring price convergence among the EU states, it should enable the consumer to make price comparison among the member states because of improved price transparency (Debra, & Colin, 2007, p. 169). The same transparency in this case will be extended to wage and other costs in labour, which are believed to increase the collective bargaining of the European Union. However, this effect has not yet been felt among the European states. The supply patterns could also be affected by the price transparency as the exchange rate risk elimination will enable the firms within the European Union to optimize their sourcing (Hayo, 2003).. In sectors such as banking, cars, pharmaceuticals, and financial services, price convergence is expected because of the transparency (Hayo, 2003). However, in European trade region, price convergence will be difficult to achieve because of existing differences in cost of transportation, existence of cross-border shopping costs, variation in tastes and preferences, different situations of competition, and difference in local costs (Debra, & Colin, 2007, p. 170). It has been argued out that the benefits of economic and monetary union are related to the size of the union. The larger the union in terms of membership, the more the European businesses will benefit from the EMU. The economic and monetary union has been regarded by the political opponents as an exercise with less positive economic impact on the member states (Debra, & Colin, 2007, p. 163). However, the big concern here is that whether the involved states are similar in terms of their economic growth and development for them to co-exist with a similar currency (Debra, & Colin, 2007, p. 163). The fact that all the member states of EMU are not at the same trade cycle stage, is a clear indication that sustaining convergence among the states will be a big problem. For example, the Britain delayed to be EMU member because of its level of trade cycle which was quite different from the other states. Another example is that of Ireland (O'Hagan, 1995). In 1973, Ireland performed poorly in terms of per capita income among the European countries. As a result of its dynamic growth in 1990s, Ireland had its per capita income highest among the community members (O'Hagan, 1995). In the early years after launching of EMU, when common currency was introduced, set of restrictive monetary policy and higher rates of interest which were not in favor of Germany and Italy which were struggling to eliminate unemployment, and stabilize economic growth, it would have been the best time for the Ireland to join EMU (O'Hagan, 1995). The question to ask here is whether a single monetary policy is suitable for all states. The implication from the above example is that unless economies of different countries are aligned, some states will experience an inappropriate rate of interest (Debra, & Colin, 2007, p. 171). Therefore, the EU should give much attention on how factor mobility could be boosted so as to eliminate the differences and, evaluate whether close integration among the member states can assist in aligning the cycles closely (Hayo, 2003). The serious problem facing the success of economic and monetary union is lack of real convergence among the member states. Lack of real convergence between the states exposes the economies of the European countries to asymmetric economic shocks. As discussed above, the asymmetric economic shocks will make the different eurozone areas to be affected differently (Hayo, 2003). For example, some states could be experiencing higher inflation rates while others facing rising unemployment levels. If this is the case, it becomes hard for the European Union to implement use of one monetary policy among the member states (Hayo, 2003). It will be possible to implement one monetary policy if only the economies of different countries experience symmetrical economic shocks, or there is availability of enough response mechanisms such as resource flexibility and mobility, or fiscal transfer within the economies of the involved countries so as to compensate the impact of asymmetric economic shocks (Hayo, 2003). The policy makers in the process of complementing the indigenous enterprises competitiveness have encountered new challenges under the EMU. The competitive devaluation as an option in securing competitiveness in the markets in foreign countries is clearly ruled out in terms of trade with non EMU members in European Union (Debra, & Colin, 2007, p. 172). For this matter, firms belonging to the state members of EMU should change costs and show higher level of flexibility if they have to survive and succeed in foreign market and European market. Therefore, governments in European states should ensure flexibility by freeing the forces in the market, in both product market and factor market (Debra, & Colin, 2007, p. 172). Conclusion The introduction of economic and monetary union (EMU) was aimed at realization of European integration. Although the launch of EMU has been successful, the cost of being a member of the union is greater than the benefits gained. The fact that the economies of European Union states are not the same, poses the big challenge in the use of one monetary policy. Also, since the different economies do not face the same economic shocks, make it hard for the individual states to respond to the shocks. The reason to this is because, under EMU, individual states have got no authority to exercise national monetary policy; this exposes the state economies to serious economic threats. The fact that it is hard to eliminate completely price differentials among the EMU member states makes it difficult for European Union members to use single currency. This also makes it impossible to have price convergence within the eurozone. Therefore, for any country willing to join the economic and monetary union must evaluate its level of economic growth and development. It should also examine the likely benefits it will get from joining the union. References: Apel, E. 1998. European monetary integration 1958-2002, p. 118-125 Chabot, N. 1999. Understanding the euro. New York: McGraw-Hill, p. 23-25 Copeland, L. 2000. Exchange rates and international finance. London: Pearson Education, p. 265-268 De Grauwe, P. 2005. The economics of monetary union, 6th ed. Oxford: Oxford University Press. Debra, J. & Colin, T. 2007. European business. 2nd ed. London: Routledge, p. 162-172 El-Agraa, A.1994. The Economies of the European Community. London: Harvester Wheatsheaf. Feuerstein, S. & Grimm, O. 2004. The road to adopting the euro. Intereconomics, 39(2), 65-81 Hayo, B. 2003. European monetary policy: Institutional design and policy experience: Intereconomics, 38(4), 2009-218 O'Hagan, J.W. 1995. The Economy of Ireland. London: Gill & Macmillan. Weber, A. 2000. The euro: A challenge and opportunity for financial markets: London: Routledge, p.3-10 Read More