Why Have the Euro and the European Central Bank Been So Successful - Essay Example

Why have the Euro and the European Central Bank been so successful? Table of Contents Introduction 3 Success of Euro 3 Success of European Central Bank 6 Conclusion 9 Bibliography 13 Introduction European Monetary Union thought to be a dream came into existence in 1999. The Euro was introduced as an accounting unit and electronic currency in January 1999, and has been circulating in Germany, Austria, Spain, Belgium, France, Greece, Finland, Italy, Ireland, Portugal, the Netherlands and Luxembourg. The population of this zone is slightly higher than the United States (Dominguez, 2006). As a currency Euro is important for the development of the global economy. The use of Euro as a common currency by the member states of European Union (EU) will help in eliminating currency risks, transaction costs and narrow the interest spread in the member countries. The European Central bank (ECB) was created as an independent institution for the establishment of a common monetary policy (Cotter, 2005). Success of Euro The use of Euro as a common currency by the member states of European Union (EU) will help in eliminating currency risks, transaction costs and narrow the interest spread in the member countries (Kramer, Kyriakopoulos, 1999). As a single European currency, Euro has succeeded in breaking barriers between people, markets and companies. It also saved Europe from the credit crisis that originated in US in 2007-08 that later spread worldwide (Yale University Press, n.d.). The success of Euro is evident from the strengthened political connections and turnaround of economic fortunes. It has acquired the second position after U.S. dollar in its use and position in the capital and international money market. For a currency circulating in the market for just four years, it is a remarkable achievement. The success of Euro can be attributed to the benefits derived from it some of which are mentioned below: Boost in cross border trade The main benefit of using Euro as a currency is that the businesses operating in the Euro zone can do all their transactions in the Euro. This avoids them from the hassles of paying in different currencies. Previously, when the company used to trade with a member of the EU, it was constantly exposed to the fluctuations in exchange rates. This led to higher export prices. Prior to Euro, the exchange costs used to be roughly €20 to 25 billion in a year which was approximately 0.3% to 0.4% of Gross Domestic Product (GDP). The use of Euro has helped in saving these costs which can now be used for other productive investments. The elimination of the costs and exchange related risks has pushed up the trade within the Euro area between 4 percent and 10 percent. This is possible only due to the increase in cross border trade for the companies are encouraged to sell in a larger market and can also avail the benefits of better goods or reduced cost. Improved planning and investment Before the use of Euro the firms had to face interest rate fluctuations which adversely impacted their costs. But with Euro the inflation rate has stabilized which has positively affected the rate of interest. This has enabled the firms to borrow funds at a cheaper cost and has also pushed up the investments. The role of the European Monetary Union has further increased the confidence of the firms in making long term investments. With the reduced uncertainty about the future, due to the sound management tactics of the Union, the companies are widening up their investments instead of piling up the savings. Availability of capital The Euro has helped in integrating the financial markets in the Euro area. With the removal of exchange related risks capital can now move more freely. The harmonization of the rules in the financial markets allows the investors to channelize their investments in those areas of euro where it can be employed more effectively. Rise in international Trade As an international currency Euro enjoys the backing of EU member states. The trading nations are attracted to do business in Euro as they can access a vast market with just one currency. Also, as the companies in the Euro area are being paid and are paying in Euro, they are saved from any losses due to currency fluctuations (EUbusiness, 2009; Huhne, 2009). So, it can be seen that the use of a common currency satisfies the conventional wisdom of higher exports and imports thereby increasing the volume of trade among the member countries. Several studies have been conducted to establish the significance of a common currency in contributing positively to trade volume. Barro and Tenreyro (2003) have found that the use of a common currency boosts trade. The findings of Micco et al (2003) suggest an increase of 4 percent to 16 percent in trade as a result of using Euro (Chintrakarn, 2008).The emergence of Euro as the international currency has solved the economic problems to a great extent. It has solved the problem of coordination of sales and purchases of currencies in a world predominated by multilateral trade. The channelization of international transactions through a common currency results in efficiency gains. Moreover as more transactions are routed through a single currency i.e. Euro, its acceptability in the international markets increases because of narrow bid-ask spreads and increase in liquidity (Federal Reserve Board, 2001). The Euro is extensively used by Euro zone banks in deposit markets and in international loans. The currency accounts for nearly 46 percent of the total deposits in the last quarter of 2007. In terms of loans the currency ranks second with a share of nearly 39 percent. A regional in these areas by Euro zone banks can be noted. Starting from the date of its introduction the Euro has primarily focused on the regions that are close to its zone. Most of the interest rate products that trade over the counter are based on Euro accounting for roughly 38.9 percent of the share. The reason for this popularity can be attributed to the large levels of fragmentation of the Euro zone government bond market compared to U.S. Besides this, the turnover in the overnight index swap market is high for Euro denominated currencies when compared to other currencies. Thus, Euro is very often viewed to become so strong so as to displace the dollar as the reserve currency of the world (U.S. Department of the Treasury, 1998). Success of European Central Bank The increasing number of wars among the European nations convinced the world leaders that a lasting peace is possible only through economic and political integrity. At the behest of Germany and France, European Monetary System was created for coordinating the monetary policy and stabilizing exchange rates. The exchange rate mechanism pushed for achieving monetary union which finally led to the creation of an independent institution the European Central bank or ECB whose primary task was to establish a common monetary policy. The ECB is a part of the member states of the EU’s national central banks. The objectives of the bank are price stability and economic growth. It has the authority to issue bank notes and coins and its tasks include managing foreign exchange operations, maintaining reserves and ensuring smooth payment system. Functions of ECB The bank takes part in the open market operations technically referred as “refinancing operations” to additional liquidity to the markets. It also gives overnight loans at a marginal rate to the banks. This helps the banks in meeting their minimum reserve requirements. The banks are mandated by the national central banks to maintain reserves and also earn interest on the overnight funds. (Dominguez, 2006). The monetary policy of the Euro area is set by ECB and the Governing Council instead of their respective national Central banks (Haan, Eijffinger, Waller, n.d.). The policy strategy adopted by ECB worked surprisingly well. ECB has adopted a medium term orientation in maintaining stability in prices. This orientation recognizes the importance of variable and long legs of monetary transmission (Kashyap, 2006). While designing the policies sufficient care was taken to ensure that the ECB is free from any political influence. The ECB is governed by the Governing Council and by itself is capable of performing financial market operations. It regularly publishes the reference rate for money growth and by doing so the bank gives a prominent role to money. The bank also releases press statements for any changes relating to policy changes. Besides this the president of the ECB gives explanation for the Governing Council’s decisions. The ECB has been successful in making the prices stable on a medium term basis. Accountability of ECB An independent Central bank is accountable to the public for all its actions. ECB too has to comply with the reporting obligations. As per the statues ECB is mandated for publication of quarterly reports along with the Weekly Financial Statement and has to also prepare an Annual Report. This report is addressed to the European Council, European Commission, EU Council and the European Parliament (European Central bank, n.d.). Credibility and Transparency in the operations Transparency requires the central banks to give a clear picture of its policies, strategies and procedures to the public as well as the markets. This is considered as a crucial factor by the ECB and the institution gives importance to its interactions and communications with the public. This also enables the public to understand the monetary policy of the institution. All this enhances the credibility and effectiveness of the policy. ECB encourages credibility by being transparent in the performance of its tasks. It really helps if the central banks are open about the extent to which they expect the monetary policies to work. The regular declaration also ensures that the markets are able to understand the pattern of response of the policies to the economic shocks. If the market can effectively understand the policy responses it not just enhances the efficiency in the implementation of the monetary policy but also facilitates quick implementation of the changes in the financial variables (European Central bank, n.d.). The ECB enjoys a high rating in the various indicators of disclosure of central banks. Results indicate that the credibility of the ECB has increased over time. Although as per accountability ECB does not rate high it specifies the more details than are required by law (The European Central Bank: Credibility, Transparency, and Centralization (Haan, Eijffinger, Waller, 2005). Even though the institution has faced a number of challenges it has only been mildly bruised. The things could not have been any better for ECB (Cecchetti, Sullivan, 2002). Through its credible and sound maintenance of the price stability over a medium term horizon the ECB can contribute to employment generation, for achievement of long term economic growth and establishing improved standard of living. The ECB’s monetary policy is widely acknowledged in making the inflation expectations in alignment with the ECB’s price stability definition. Further the financial markets confirm the credibility of their monetary policy. The increase in the inflation in the Euro area following the issue of bank notes and coins was anticipated by ECB. However in the long run there will be a downward shift in prices as a result of the increased transparency and stiff competition in prices that the Euro is inducing (European Central Bank, 2002). The ECB is reputed for guarding the stability in Euro and has been appreciated for its efforts in calming the financial turmoil in the markets after August 2007. Conclusion The Euro has all the factors that are needed in a competitor of dollar but it lacks the political power. The dollar is trading at low levels against Euro which is still in the nascent stage. This has brought it to the notice of many policymakers and pundits. In the initial years the share of Euro in international foreign exchange reserves increased more than the reserve currency position which attracted the reserve managers of the central banks. References European Central Bank. 2002. Success factors of the Euro and the ECB. Available at: http://www.ecb.int/press/key/date/2002/html/sp020213.en.html [Accessed on November 9, 2009]. Cecchetti, S. Sullivan, R. 2002. The European Central Bank and The Federal Reserve. Available at: http://people.brandeis.edu/~cecchett/pdf/cecchetti%20osullivan%202003.pdf [Accessed on November 9, 2009]. Haan, J. Eijffinger, S. Waller, S. 2005. The European Central Bank: Credibility, Transparency, and Centralization. Massachusetts Institute of Technology. European Central bank. No Date. Transparency. Available at: http://www.ecb.int/ecb/orga/transparency/html/index.en.html [Accessed on November 9, 2009]. European Central bank. No Date. Reporting obligations. Accountability. Available at: http://www.ecb.int/ecb/orga/accountability/html/index.en.html [Accessed on November 9, 2009]. Kashyap, A. 2006. Stability First: Reflections inspired by Otmar Issing’s success as the ECB’s chief economist. Available at: http://faculty.chicagobooth.edu/anil.kashyap/research/STABILITYFIRST_finalnberwp.pdf [Accessed on November 9, 2009]. Dominguez, K. 2006. The European Central Bank, the Euro, and the Global Financial Markets. Journal of Economic Perspectives. Available at: http://www-personal.umich.edu/~kathrynd/JEP.ECB&Euro.Fall06pdf.pdf [Accessed on November 9, 2009]. Yale University Press. No Date. Introduction: The Story of the Euro. 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