Single currency costs and benefits - Term Paper Example

 Assess the costs and benefits of a single currency. Should UK adopt the Euro? I. Introduction One of the major requirements for the successful operation of an organization is the cooperation between its members and the application of a common strategy. In a similar context, the existence and the survival of the European Union cannot be considered as possible without the recognition and the acceptance of a series of common principles and practices by all its members. Towards, that direction, the monetary union as expressed through the introduction and the use of Euro as a common currency in the member states, is an indispensable element of the success of the policies set by European Union (as a representative body of the participated countries). However, this monetary union had not been accepted by all countries of the European Union but there were cases that the national currency was considered as necessary for the domestic development. One of the most characteristics cases of such kind is that of Britain. The country having a national currency the history of which is really impressive, had chosen to keep sterling rejecting the monetary union with the other members of the European Union. This paper examines the issues related with the introduction and the application of a single currency strategy as can be viewed in general and particularly in case of the European Union. Moreover, the strategy followed by UK is being examined as of its effects to the country but also to the Union both in a short and a long term basis. The findings of the literature are combined with statistical data in order to perform a complete – to the highest possible level – presentation of the issue. A series of recommendations was also considered as necessary taking into account the current practices of European Union as well as of UK regarding the monetary strategy that should be more advantageous for all the parties. II. Single currency – costs and benefits The definition of monetary union can be resulted by the description of its particular characteristics as can be observed in a specific geographical area. In this context, the monetary union has been considered as ‘the monetary unification of participating member countries in an economic union and involves the adoption of a common currency, coordinated exchange rate policies, and harmonization of fiscal and monetary policies’ [14]. The above definition has furthermore been considered as containing the following two major characteristics: ‘i) An exchange rate union, i.e. an area within which exchange rates bear a permanently fixed relationship to each other even though the rates may, in unison, vary relative to non-union currencies; and ii) Convertibility – the permanent absence of all exchange controls, whether for current or capital transactions, within the area’ [14]. The above description of the nature and the operation of a monetary union within a specific area although containing two of the basic elements of this type of ‘financial co-ordination’, however, it can be considered as incomplete as it refers partially to the financial aspects of this union and do not present all the forms of its application within a geographical framework. The introduction and the use of euro as a common currency in the European market have been followed by a series of advantages for the participated countries. At a first level it is stated that the Economic and Monetary Union have created a single market which is completed through the application of fixed exchange rates between the member states. In this context, euro has caused the reduction of transaction costs and has made prices more attractive and transparent in the European market area which is governed by a series of principles among which is the fundamental principle for the freedom of movement as related to persons, goods and services. As a result of the above activity, the competition has been increased and so did the innovation in the European area. Additional strengths of the euro area has been considered ‘the favourable external position in terms of assets and current account, a highly trained and skilled labour force, and a high level of technology and innovation in production’ [1]. Furthermor, the Euro ‘has energized Europe's wholesale capital markets, spurring the rapid growth of Euro-denominated corporate bonds, equities, and syndicated loans’ [17]. The acceptance of euro has also created a series of other positive effects for the member states the most important of which has to be considered the provision of a stable macroeconomic environment while EU has also gained greater purchasing power with a stronger currency (Spain which has acquired a currency which is 166% increased comparing the national one – peseta – can be mentioned as an example)’ [9]. Furthermore, ‘the consolidation of the Single Market has to be considered as important in itself as it will increase efficiency in production because of increased specialisation and economies of scale, thus increasing the European Union's level of GDP’ [15]. On the other hand, it has been stated that companies will be obligated to follow a similar framework avoiding large price differentiations between member states. Such an obligation could be imposed mainly through the existence of standardized exchange rates (as resulted by the use of euro by all participated countries). In this context, it has been stated that since’ there still will be variations between national markets, such as cultural differences, developing a euro price list will be strategic exercise that must be effective from a marketing as well as a financial standpoint; moreover, banks could benefit from the reduced currency risks that EMU promises as a single currency removes much of the need to hedge against exchange-rate fluctuations in the region’ [18]. The above effects, if taken together they can lead to the assumption that ‘the economic opportunities to improve growth, employment and living standards in Europe in a lasting manner through Economic and Monetary Union are enormous’ [1]. The combination of these effects can also lead to a financial stability in the European market both in short term but mainly in a long term basis. In the area of literature, the phenomenon of financial stability of the countries participated in the monetary union has been explained mostly through the theory of hegemonic stability which states that ‘a stable economic system is most likely to exist when a dominant hegemonic power is present to establish and enforce a regime; in this theory, one state, possessing a great deal of power and influence is effectively able to coerce other states into agreement [9]. According to the above theory, the main actor for the success of monetary union in Europe is Germany which has been traditionally considered as a leading country in the Union with a characteristic level of financial strength (which although has been under consideration the last years). On the other hand, although the introduction and the use of euro can be considered as a very successful strategy, it has to be noticed that there are a few issues that need thorough examination. In this context, it should be highlighted that the European Monetary Union has been followed by a significant increase to the level of unemployment in the member states whereas the rate of growth of the particular countries had also been disappointed. These phenomena, which appeared almost simultaneously with the adoption of the common currency by the member states do not seem to be reduced through the years but on the contrary can be considered as slightly increased comparing to the past (the initial period of the application of the common currency in EU). One of the most important reasons for the problems that seem to follow the application of the monetary union is the differentiation of the countries participated in the Union. This differentiation does not refer simply to cultural issues but it is mainly involved in differences to the structure of the economy and the general political system followed by each particular state. This assumption is also supported by the view that ‘when economies with different fundamental economic structures, levels of efficiency, productivity and inflation are integrated under a single currency, the negative effects for the participated countries should be considered as expected because if all economies were the same and had similar objectives they would possibly adopt the same policies and respond in the same way to changing circumstances, thus eliminating many of the advantages of fixed exchange rates’ [15]. The above assumption can also explain the efforts that are usually made towards the fixing of exchange rates, which is necessary in order ‘to constrain national monetary authorities from short term political aims for the sake of overall efficiency gain’ [15]. In practice, the efforts for the adaptation of exchange rates to a common framework has not been successful mostly because of the existence of significant differences among the interested countries as these differences can be observed mostly in the area of market structure as well as in the policies followed in financial transactions. According to Albanesi et al. (2001, 370) ‘one of the standard arguments often made in favour of a common currency, is that it promotes economic and financial integration and reduces transaction costs; these benefits have to be balanced against the costs associated with the loss of monetary independence that a currency area necessarily implies as this loss of monetary independence means that the country can no longer use the instruments of monetary policy to adjust to internal or external shocks’. However, Dibooglu et al. (1997, 37) seem to have a total different view on the specific issue, i.e. on the benefits offered by the introduction of a monetary union and the implication that may follow. More specifically, the above researchers have found that ‘there are several potential benefits of currency union membership; first, it would bring maximum credibility to exchange rate stability by eliminating risks and transaction costs stemming from exchange rate operations inside the currency union; second, members might obtain some efficiency gains by avoiding negative externalities associated with beggar-thyneighbor type policies; finally, a currency union might enable monetary authorities to pursue monetary control more effectively as a result of money demand becoming more stable in a wider area under open capital markets and full financial liberalization’. The above benefits, as described from a theoretical view, they cannot however reduce the importance of a negative effect which usually follows the application of monetary union in every country around the world, this of the loss (or the limitation) of the national independence. More specifically, the application of a monetary union among a series of countries is usually followed by a series of common principles and practices that these countries have to follow in order to achieve specific financial targets as set by the controllers of this union in advance. This, in practice, means that the country has for the future a limited power of decisions regarding its financial policies and furthermore that it will be supervised by specific authorities (which control the operation of the whole union’s processes) regarding all its financial activities. This issue can be considered as the most significant cost regarding the application of a monetary union while any benefit that may be considered as gained in such a financial co-operation cannot eliminate the influence of this effect to the nation involved. Figure 1 - Selected MFI interest rates (weighted averages on new business) [21] III. Economic integration of UK – costs and benefits The acceptance of European Monetary Union by UK has been related with a series of tests which have been summarized by Artis (2000, 71) to the following ones: a) whether there can be sustainable convergence between Britain and the countries of the single currency; b) whether there is sufficient flexibility to cope with economic change; c) the effect on investment; d) the impact on our financial services industry; and d) whether it is good for employment’. The particular terms for the evaluation of these tests as successful of not have not been proposed but the issue has been left on the government’s will to decide. In this context, Barrell (2002, 68) tried to examine the criteria for the evaluation of the above five tests (as set by the UK government as basic criteria for the country’s decision regarding its participation in the EMU). After a thorough examination of the specific problem, the above researcher came to the result that the above tests should be considered as ‘answered in the affirmative, and that the case for joining is clear’. However, he complementary stated that ‘before a final decision is made, we have to assess any short-run costs that might be incurred, and balance them against the obvious long-run benefits’. It seems from the above that the acceptance of EMU from UK will be a rather challenging experience for the specific country. This result can be possibly explained by the fact that the history of the country’s currency cannot be compared to the ones of the other member states (the currencies of which have been differentiated a lot through the years in order to be adapted to the current conditions). Moreover, it is stated that ‘whereas most European countries, large or small, have repeatedly had to carry out changes which have drastically altered their internal currencies, the pound as a unit of account has never had to be replaced by a "new pound" or any other designation in 1,300 years, in contrast to the French franc or the various German currencies such as the Reichsmark, Rentenmark, Ostmark and Deutschemark, to mention merely some of the more modern changes; England has enjoyed a relatively stable single national currency with an unbroken history of over 900 years, and the origins of the pound Sterling go back even further still’ [3]. In the area of British market, euro can be considered as a current reality – although the monetary union has not been applied in UK. The reason for this can be explained by the fact that [11] ‘businesses trading with eurozone countries find it easier and more beneficial to trade in euros because accepting payments in the specific currency often makes the goods or services on offer much more attractive to potential eurozone customers’. A very important factor for the evaluation of the EMU can be the comparison of the exchange rates regarded three major currencies, the sterling, the euro and the US dollar. According to the statistical data [23] the Euro reached a low point against the US Dollar on 25 October 2000 so that the exchange rate was €1.00 to $0.8286; since then, the Euro has increased in value to €1.00 = $1.1625 on 31 October 2003, representing an increase of 40.3% and at 30 September 2004, the Euro reached €1.00 against $1.2420, representing and increase of 49.9%; in the same period, Sterling rose from £1.00 = $1.4352 to £1.00 = $1.6970 at 31 October 2003, representing an increase in value of 18% and to $1.8096 at 30 September 2004, representing an increase of 26%’. From the above figures, the monetary union in the European area is justified as a strategic movement from the member states as the currency involved, euro, has been developed to a major competitor in the global financial market and has gained a significant nominal value in the area of international transactions. The development of euro if viewed combined with the remarkable development of Sterling can explain the limitation of the ‘power’ of US dollar in the global financial markets. Figure 2 - Percentage change of Euro, Sterling, Swiss Franc and Yen towards US Dollar [23] IV. Implications of the loss of a monetary policy In cases that a monetary union is being applied among a series of countries, the domestic market area often faces significant challenges. In this context Lotz et al. (2002, 563) found that ‘the launching of a new currency is a usual event in the monetary history of a country while the introduction of a new currency is usually explained by diverse reasons such as to avoid counterfeiting, to save production or issuing costs, to replace national currencies in the case of monetary integration, or as a means of asserting sovereignty in the case of newly created nation states’. On the other hand, Goldfajn (2003, 98) comes to the assumption that ‘in a large set of undervaluations in the aftermath of currency crises, tight monetary policy substantially increases the probability of reversing undervaluation through nominal appreciation rather than through higher inflation’. However, the above results have been found as been differentiated in cases that the specific country is facing a banking crisis. More specifically, it has been found that in such cases a tight monetary policy can lead to a different result, as to the reduction of ‘the probability of a reversal of currency undervaluation through currency appreciation’. Furthermore, regarding the effects of tight monetary policy on inflation, the current account balance, and output growth, Goldfajn (2003, 98) found that ‘inflation declines more sharply in the cases with tight monetary policy while the current account is improving after the implementation of tight monetary policy and remaining stronger than in the non-tight monetary policy cases’. V. Evaluation of macroeconomics concern and microeconomics of integration In order to examine the effects of a monetary union strategy in the macroeconomic and microeconomic level, we should primarily proceed to the presentation of the particular elements of these two financial terms. In this context, macroeconomics can be characterized as ‘the economics sub-field of study that considers aggregate behavior, and the study of the sum of individual economic decisions; this is in contrast to microeconomics which is the study of the economic behaviour of individual consumers, firms, and industries’ [20]. In these terms, macroeconomics ‘can be used to analyze how best to influence government policy goals such as economic growth, price stability, full employment and the attainment of a sustainable balance of payments’ [20]. The particular elements of the macroeconomic area have been examined and it had been found that the ‘sound fiscal consolidation contributes directly to credible macroeconomic stabilisation, an assumption that can be supported by the fact that the detailed observation of the member states leads to the result that only two of them, in fact, show a level of debt above the reference value, but no fewer than six countries exceed the reference value for the budget deficit’ [5]. Another issue for consideration should be the increased level of public debt among the member states the last years. This assumption has to be taken into account especially when considering the financing of the new member states, which already have ‘quite sizeable public factors in relation to their levels of income’ [5]. Under these terms, the governments of these countries should be urged to enforce their financial strength and to seek for the improvement of the level of financial stability (Barrell et al., 2005). A relevant study made by Barrell and Davis (2005, 94) showed that ‘the stability of the macroeconomy depends upon its ability to react to shocks, and institutions need to be designed to absorb shocks in order to enhance performance; shocks produce cycles, and controlling both the impact of shocks and the response of the economy to the shock are important issues for policymakers’. In this context, the current macroeconomic policy following in the European Union area is mainly characterized by the intensive efforts for the achievement of stability on a long term basis. Figure 3 - Effective Exchange Rates Trade-Weighted, Monthly Averages Indices 1975 – 2004 [23] VI. Challenges set regarding the monetary union issue The monetary union in the European market area begins in January 2002 when ‘the euro became the sole legal tender for the twelve member countries of the European Monetary Union; Jacques Delors, when asked to predict the future of the new currency in an interview in Le Figaro, quipped, “le petit euro deviendra grand”; at the first year anniversary of full conversion to the euro, Delors’ prediction proved accurate as the euro, undervalued since 2000, reached parity with the dollar’ [4]. The years that followed the introduction of euro as the basic currency among the member states has being characterized by great challenges and turbulences. During the years that have followed the introduction of euro, a series of changes has been made in the internal of all member states. It can be noticed that although the National Banks continue to exist, the fundamental decisions of economy (like level of exchange rates) are being taken by the European Central Bank (ECB) which began its activity in 1999. In this context, it is stated [7] that ‘moving to a single currency may initially have been a practical decision in the context of the single market, but behind this economic and monetary union is a profoundly political project while the ongoing discussions in Denmark, Sweden and the UK – and indeed in some of the eurozone countries – about ‘economic sovereignty’ illustrate the political faith required to adopt (and keep) the euro’. On the other hand, it is highlighted that ‘while a weaker euro allowed EU economies to coast along on exports, a stronger euro will put greater pressure on national governments to increase productivity and investment, to implement a single market in financial services and regulations, and to seriously address the issue of fiscal harmonization; the costs of enlargement cannot be underestimated but this should not hamper internal reforms and further harmonization [4]’. These views which are mainly connected with the prospect of EU’s enlargement (as the phenomenon can be observed the last years) although justified by the empirical results related with the EMU, are however only partially applied in practice by the member states because of the existence of a series of parameters that put limitations to the power of the state to proceed to fundamental reforms regarding its financial strategies (Blake et al., 2002). Figure 4 - Euro – Dollar daily Moving Average [22] VII. UK and Euro – Should the country be positive or negative to a possible The implications for Britain of its independency from Europe regarding the currency are really important. At a first level, the UK ‘will have no vote on the appointment of the new president, vice-president and other members of the executive board of the European Central Bank nor will it have a say on the monetary policy pursued by the ECB in the euro zone; the ECB will act as spokesman for this group in international forums such as the G7, where Britain's voice will be diminished’ [8]. Furthermore, ‘inside the Ecofin council of European Union finance ministers - perhaps the most powerful political forum outside the six- monthly EU summits - the UK position will also be eroded’ [8]. It has to be noticed however, that the negative effects for the absence of UK from EMU are limited only to issues of ‘administrative nature’ and do not involve in the country’s financial development which presents a remarkable development. The above assumption can be explained by the fact [23] that it is ‘the sterling/dollar rate which matters most to the British economy’. This interaction between the British and the USA economy can be supported by the following facts [23]: a ) the USA is by far the UK's largest single export market, (absorbing 17 percent of the UK's visible and invisible exports, as much as Germany and France combined); b) the USA is the biggest overseas investor in the UK (accounting for 63 per cent of all foreign direct investment (FDI) earnings in the UK, compared with 17 per cent for the whole of the EU); c) the UK is the largest overseas investor in the US, which provides 34 per cent of worldwide UK FDI earnings (compared with 18 per cent from the EU)’. IX. Conclusion When examining the strategy that should be applied by a country in the monetary area, there are several issues that should be considered thoroughly before proceeding to any assumption. At a first level, the interaction of the specific country with other states in both cultural and financial areas creates the necessity for the application of common principles that will regulate the relevant transactions/ exchange of ideas, services, and products. From a theoretical point of view such an interaction can be very complicated and a lot of time has to be spent towards the achievement of such an aim. However, in practice the harmonization of the existed national strategies with the ones governed the international relations can help to the reduction of the time needed for such an effort. On the other hand, when the issue is the change of the existed monetary policy and the currency involved, then the whole procedure can be really time consuming while the result cannot be predictable in advance. In this context, the absence of UK from the EMU schema can be partially justified because of the significant risks that would follow such an initiative. However, in a long term basis, the specific country will have to follow the rules and the strategies set by the European Union in all their aspects (including the monetary policy) in order to remain an active member of this Union. References Albanesi, S., Christiano, L. J., Cooley, T. F., Quadrini, V. (2001). The Costs of Losing Monetary Independence: The Case of Mexico. Journal of Money, Credit & Banking, 33(2): 370-392 Artis, M. (2000). Should the UK Join Emu. National Institute Economic Review, 70-84 Barrell, R. (2002). The UK and EMU: Choosing the Regime. National Institute Economic Review, 54-74 Barrell, R., Choy, A., Holland, D., Riley, R. (2005). The Sterling Effective Exchange Rate and Other Measures of UK Competitiveness. National Institute Economic Review, 191: 54-65 Barrell, R., Davis, E. P. (2005). Policy Design and Macroeconomic Stability in Europe. National Institute Economic Review, 191: 94-107 Begg, I., Hodson, D., Maher, I. (2003). Economic Policy Coordination in the European Union. National Institute Economic Review, 66-81 Blake, A. P., Byrne, J. P. (2002). Sterling, the Euro and the Dollar. National Institute Economic Review, 44-47 Cencini, A. (2001). Monetary Macroeconomics: A New Approach. Routledge, London Dibooglu, S., Horvath, J. (1997). Optimum Currency Areas and European Monetary Unification. Contemporary Economic Policy, 15(1): 37. Goldfain, I., Gupta, P. (2003). Does Monetary Policy Stabilize the Exchange Rate Following a Currency Crisis?. IMF Staff Papers, 50(1): 90-105 Handa, J. (2000). Monetary Economics. Routledge, London Jacquemin, A., Jovanovic, M. N. (1997). Limits and Prospects. Routledge, London Jovanovic, M. N. (1998). International Economic Integration: Limits and Prospects. Routledge, London Lotz, S., Rocheteau, G. (2002). On the Launching of a New Currency. Journal of Money, Credit & Banking, 34(3): 563-579 Mcadam, P., Morgan, J. (2004). The Effects of Euro Area Interest Rate Changes: Evidence from Macroeconomic Models. National Institute Economic Review, 187: 93-107 Pedram, M. (2001). Regional Monetary System. East European Quarterly, 35(2): 201-208 Scobie, H. M. (1998). European Monetary Union: The Way Forward. Routledge, New York Walsh, J. I. (2000). European Monetary Integration & Domestic Politics: Britain, France, and Italy. 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