The Case for Euro-Zone Membership - Essay Example

?The case for Euro-zone membership Introduction The utter devastation of the World War II in Europe led to new thinking. In attempts to discover a new more sustainable future it was identified by many that ‘Europeans’ needed to be united. The most noted of such attempts was the European Coal and Steel Community and the European Economic Community in the 1950s formed by six countries of Europe. This is recognized to be the initial influence for the European Union (EU). After years of evolvement, European Union was formed under its present name in 1993 by the Maastricht Treaty. With a current membership of 27 countries, the EU functions via a hybrid system of supranational self-governing institutions(Albi,2005) and international decisions negotiated by the member states. Every five years EU citizens elect the European Parliament. Other significant EU institutions include the European Commission, the Council of the European Union, the Court of Justice of the European Union, the European Council, and the European Central Bank. Thereby EU has created one market through a uniform system of regulations which apply in all member countries. As a final stage of economic integration of the EU a monetary union (an optimum currency area) was formed. The Economic and Monetary Union (EMU) of 17 EU member states who have accepted the euro (€) as their common currency and solitary legal tender, makes the Eurozone, which is officially known as the euro area. Eurozone currently includes Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain. Other EU member states are expected to fulfil the strict entry requirements to enter the Eurozone while some EU states namely Sweden, Denmark and the United Kingdom has chosen to stay outside the Eurozone. European Central Bank carries the responsibility of the monetary policy of the area, whereas other zone/euro related decisions are co-operated through the euro group. Part A and B of this paper will review the case for Eurozone membership in regard of the optimum currency area theory and issues with fixed exchange rate systems respectively. Thereby finally the paper will conclude how the Eurozone membership can be attractive to new applicants. A) Optimum currency area theory in the Eurozone A geographic region which would maximize economic efficiency by the entire region sharing a single currency is known as an optimum currency area (OCA). The earliest mention of the concept was by Abba Lerner (Scitovsky, 1984); although most acknowledged development of the pertaining theory goes to Robert Mundell. Mundell argues that for perfect regional economic integration the said region must be an OCA. Thus he presented two simulations. First was an OCA with fixed expectations: the argument in brief is that uneven shocks are considered to challenge the real economy. These shocks are significant and cannot be organised. Also the international monetary policy (interest rates) cannot be modified for a specific situation of each integral region. Thus a regime with floating exchange rate is considered better than a fixed regime (Mundell, 1961). By this means the properties (Mongelli, 2008) of a successful optimal currency area are reviewed below. Mobility of factors of production including labour. High market integration inside a group of partner countries can lessen the need to modify real factor prices and the nominal exchange rate between countries in reaction to disturbances (Mundell, 1961). The belief that mobility of factors of production enhances both efficiency and welfare was confirmed by the trade theory. Such mobility is likely display its effect in the long-run. The production factors’ mobility is restricted by the speed that direct investment can be generated by one country and absorbed by another. Likewise, labour mobility which includes physical capability to travel (workers' rights, visas, etc.), lack of cultural blocks to free movement (such as different languages and behaviour habits) is likely to be low in the short run, due to significant costs, such as for migration and retraining. Mobility, however, may increase in the medium and long run, easing the alteration to permanent shocks (Mongelli, 2008). As in the case of the Eurozone, the mobility of direct investment is high while labour mobility is relatively low, especially when equalled to the U.S. Price & wage flexibility and Openness with capital mobility across the region. When prices and wages are flexible amid and within countries contemplating a single currency, the evolution towards alteration after a shock is less likely to be related with sustained unemployment in one country and/or inflation in another (Mongelli, 2008). The market forces of supply and demand habitually distribute capital and goods to where they are needed. Practically this perfection is impossible as there is no true wage flexibility. (McKinnon, 1963) The Eurozone member countries trade greatly with each other so much that their international trade is less than intra-European. Confirming this is a recent empirical research of the ‘euro effect’ which concludes that the single currency (euro) has trade growth of 5% to 15% in the Eurozone, compared to trade between non-Eurozoners. (Bladwin, 2006) A convenient risk sharing system (Fiscal integration): For example, a spontaneous financial transfer instrument to redistribute money to areas/sectors that have been unfavourably affected by the first two properties. This can take form in taxation redistribution to less developed areas of the region. This policy is politically difficult to implement as the richer regions are unlikely to give up their revenue without return. Thus a higher degree of political integration would be required. (Mongelli, 2008). According to the Stability and Growth Pact (1997), Eurozone has no bail-out terms. In other words monetary transfers are unacceptable. However during the European sovereign debt crisis in April 2010, the clause was abandoned and Eurozone member Greece was bailed out. Member countries have similar business cycles: When a country is in an economic boom or recession, other countries in the zone are expected to follow. This enables the common central (European Central Bank) to encourage growth in recessions and to enclose inflation in booms. However if members of the currency union have distinctive business cycles, then optimal monetary policy may deviate and union members could be in crisis under the common central bank. This happens to be a risk tolerated by each member of EMU Diversification in production and consumption: High diversification in production and consumption, such as the “portfolio of jobs”, and consistently in imports and exports, minimises the possible impact of shocks specific to any particular sector. Thus more diversified partner countries are more likely to incur lesser costs as a result of neglecting nominal exchange rate changes between them and thereby find a single currency advantageous. (Mongelli, 2008). The amount of Economic openness: : Fluctuations in international prices of tradables are more likely to be reflected in the domestic cost of living when the degree of openness is higher. The second model by Mundell in 1973 concerns OCA with international risk sharing. Where he argues that a flexible (uncertainty risk) exchange rate regime1 will hinder the economy. Thereby considers fixed regime to be better. “…the European currencies were bound together disturbances in the country would be cushioned, with the shock weakened by capital movements” (Mundell, 1973b, pp.147&150). Thus in view of the Eurozone membership, this OCA theory is in favour of the euro as a single currency and thereby the monetary union can successfully integrate the economies of the area. Concluding, we identify a contrast Mundell’s OCA arguments. The first OCA model suggests that a floating rate regime is acceptable for EMU as international economic shocks cannot be manipulated. On the other had the second model identifies that a fixed rate regime would be better equipped to absorb such shocks within the Eurozone as an OCA. Thereby the European way of dealing with this complexity of a single currency is illustrated in Figure 1 by Mongelli. In his paper he explains an ‘impossible trinity’, which refers that free trade and capital mobility; monetary policy autonomy; fixed exchange rates cannot be resolved. Governments must decide and choose. With free trade and free capital movement (open markets) at least for a short-term, free-floating of the exchange rate is an essential condition to secure some monetary independence. Contrariwise, renouncing monetary policy independence is necessary to maintain fixed exchange rates. (Mongelli, 2008). Consequently the EMU way (ref Figure 1) is to allow a fixed exchange rate regime within the Eurozone market while a flexible regime is practised internationally (i.e. out of the Eurozone). Figure 1 The European way to solve the 'impossible trinity' Source: (reference Mongelli, Feb 2008, pp.13) b) economic issues with fixed exchange rate regimes Exchange rate regime in the Eurozone is set by the European Exchange Rate Mechanism (ERM). As presented in the figure 1 EMU deals with both fixed (pegged within the EMU) and flexible exchange rates (out of the EMU). This hybrid system is known as semi-pegged exchange rate regime (Ghosh et al, 1996) and the ERM is based on this. The characteristics of the fixed regime within the Eurozone are as follows (tutor2u.net). Pledge to a single fixed exchange rate No allowable fluctuations from the central rate Achieves exchange rate stability possibly at the expense of domestic economic stability These criteria are identified to concern with two main economic issues; inflation and growth - two vital macroeconomic variables (Ghosh et al, 1996). Inflation: It has been long established by literature that a fixed exchange rate can be an anti-inflationary instrument. The prominent classically cited reasons are that; one, it provides a highly transparent pledge and thereby increases the political costs of loose financial and monetary policies; two, depending on the credibility of the fixation, there is a stronger keenness to hold domestic currency (euro in this case), which reduces the inflationary magnitudes of a given expansion in the money supply. Thus a fixed exchange rate lowers inflation in the EMU by persuading greater policy discipline and implants greater sureness in the Euro as a common currency (Ghosh et al, 1996). However it is a possibility that the inflationary pressure could build-up (but be held in place) in a period of fixed exchange rates. This could explode into open inflation when a re-valuation/float is approved. In such circumstances, the high inflation should rightly be attributed the fixed regime rather than the float which is often the case. (Ghosh et al, 1996) Growth: Classical theories of fixed exchange regimes on the growth of output, focuses on the influence on international trade and investment. Supporters state that pegged regimes nurture investment by lowering policy doubts and reducing real interest rates. Others argue that, by eradicating an important adjustment instrument, fixed exchange rates can increase protective pressure, misrepresent price indications in the economy, and thereby thwart the efficient division of resources across sectors. These arguments are confirmed in the Eurozone as well where investments are increased while slow growth in division of resources (e.g. labour mobility). Furthermore on a detailed analysis by Ghosh et al confirms that economic growth is influenced by exchange regimes. The findings suggest that a pegged regime have higher investment and is correlated with much slower productivity growth compared to floating regimes which have faster productivity growth. In conclusion, we identify that a fixed exchange rate regime results lower inflation while slowing the economic growth. Conclusion: The attractiveness of Eurozone membership for new applicants The attractiveness of the Eurozone membership for new applicants mainly stems from the OCA properties (ref part A). Mainly the adaptation of the Euro causes economic costs to reduce or even disappear. For instance direct and indirect reduction of trading costs by eliminating exchange rate risks and currency hedging costs. Price transparency is encouraged while price discrimination is discouraged. This reduces market segmentation and facilitates competition. As a medium of exchange unit the common Euro is more efficient than multiple currencies and can also encourage union in social contracts with theoretically far reaching legal, contractual and accounting consequences (Mongelli, 2008). The Euro among member countries can be interpreted as “a much more serious and durable commitment” (McCallum, 1995). It prevents future competitive deflations; accelerates foreign direct investment and erects long-term relationships; and encourages positive of political integration. This will stimulate equal trade (productivity/economic shocks may spill over via trade), economic and financial integration and even nurture business cycle synchronisation for better risk absorption for the new applicant. The engagement of these benefits depends on the financial integration. Other important sources of direct and indirect benefits (Mongelli, 2008), for a potential Eurozone member are listed in figure 2. Figure 2 Sources of benefits and costs The major risk today is the persistent fragility of the economies of some Eurozone member countries such as Greece, Spain, and Portugal, and the possibility of renewed rumour in the financial markets (Cameron, 2010). Therefore attractiveness of the Eurozone to potential applicants depends on a more detailed and applicant specific cost benefit analysis. References 1. Anneli, A. (2005). "Implications of the European constitution". EU enlargement and the constitutions of Central and Eastern Europe. Cambridge, UK: Cambridge University Press, 2008. p. 204. 2. Baldwin, R. & Wyplosz, C. (2004). The Economics of European Integration. New York: McGraw Hill. ISBN 0077103947. 3. Baldwin, R.(2006). In or Out: Does it Matter? An Evidence-Based Analysis of the Euro's Trade Effects. London: Centre for Economic Policy Research. ISBN 189812891X. 4. Cameron, F. (2010). “The European Union as a Model for Regional Integration”, Council on Foreign Relations, Retrieved: 12 April 2011. http://www.cfr.org/eu/european-union-model-regional-integration/p22935?excerpt=1 5. Frankel, J. A. & Rose, A.K. (2001). "The Endogenity of the Optimum Currency Area Criteria". The Economic Journal 108 (449): pp.1009–1025. 6. Ghosh A.R., Ostry J. D., Gulde A. &Wolf, H.C. (1996), “Does the Exchange Rate Regime Matter for Inflation and Growth?” International Monetary Fund, URL: http://www.imf.org/external/pubs/ft/issues2/ 7. McCallum, J. (1995), “National Borders Matter: Canada – US Regional Trade Patterns”, American Economic Review, 85(3), 615-623. 8. McKinnon R. (2004), “Optimum Currency Areas and Key Currencies: Mundell I versus Mundell II,” Journal of Common Market Studies Vol. 42, No. 4 pp. 689-715. 9. McKinnon, R. (1963), “Optimum Currency Areas”. American Economic Review, Vol. 52, pp. 717-725. McKinnon, R. (1993), “Common Monetary Standard or a Common Currency?”, Rivista di Politica Economica, Vol. 83, pp. 151– 9. 10. Mongelli, F.P (2008), “European economic and monetary integration and the optimum currency area theory”, European Commission Economic Paper no. 302, February 11. Mundell, R. (1973a), “Uncommon Arguments for Common Currencies”, in H. Johnson and A. Swoboda, ed., The Economics of Common Currencies. 12. Mundell, R. (1973b), “A Plan for A European Currency”, in H. Johnson and A. Swoboda, ed.,The Economics of Common Currencies 13. Mundell, R. A. (1961). "A Theory of Optimum Currency Areas". American Economic Review 51 (4): pp.657–665. 14. Ricci, L. A. (2008). "A Model of an Optimum Currency Area". Economics: the Open-Access, Open-Assessment E-Journal 2 (8): 1–31. 15. Scitovsky, T. (1984). "Lerner's Contribution to Economics". Journal of Economic Literature 22 (4): pp.1547–1571 16. "European Union". Encyclopaedia Britannica. Retrieved 11 April 2011. 17. "European Union". The World Factbook. Central Intelligence Agency. Retrieved 11 April 2011. 18. “Fixed floating”, tutor2u.net., Retrieved: 12 April 2011. http://tutor2u.net/economics/content/topics/exchangerates/fixed_floating.htm Read More