The Breakup of the Eurozone Is Inevitable Within the Next Five Years - Case Study Example

Table of Contents Table of Contents 1.0 Executive summary 2 5.0 Conclusion 9 6.0 Bibliography 10 0 Executive summary Maastricht Treaty of 1992 paved way for the introduction of Economic and Monitory Union (EMU). EMU was created for political reasons though based on economic shared principles and understanding. Euro zone has built and sustained collective identity and interest among it s members1. The aim was to promote increased economic growth and development in the Euro zone. The European countries understand that economic growth and development emerge from stable macroeconomic environment, increase competition, reduction and elimination of foreign exchanges risks, and increased productivity through induced structural reforms. Countries in the Euro zone are restrained from pursuing their self- interest by mutually respecting each other’s sovereignty and independence rights. However, Euro zone must adhered to EMU operating principles. Good governance must be practice at all transactions to avoid future crisis2. 2.0 Introduction January 1, 1999 saw the official launch of the Economic and Monitory Union (EMU). On that day, eleven European countries joined the EMU and five more followed suit years later. Now, EMU is comprised of sixteen member European countries. The first to join were Austria, Belgium, Germany, France, Ireland, Italy, Finland, the Netherlands, Portugal, Luxembourg, and Spain. Greece followed in 2001, then Slovenia in 2007 while Cyprus and Malta joined in 2008. The last to join was Slovakia in 2009. EMU countries adopted Euro as a single currency for transaction purposes. The chief reasons that lead to EMU were mainly to stabilize prices, macroeconomic environment, banking system, financial markets as well as increase trade competitiveness and boost flexibility in the member countries3. Before and after the official launch, different people had different views concerning the sustainability of the Euro Zone especially on areas of viability and desirability. Supporters of EMU claimed that common currency has the potential to improve trade, attract more foreign direct investment, stabilize wages and enhance business strategies of member countries. On the contrary, they are opponents who predict that Euro zone is heading for a disaster4. They pegged their arguments on the premise that countries in the Euro Zone are diverse and put individual interest forward at the expense of the EMU. There are benefits and costs associated with Economic and Monitory Union. If costs are more than benefits, EMU may not survive in future and if vice versa, union will endure the test of time. 3.0 The advantages of the EMU (Euro zone) The first advantage is that common currency reduces costs and risks associated with foreign exchange currency. Common currency eliminates transaction cost incurred when exchanging one currency for the other5. In addition, it eliminates competitive devaluation and speculation applied by some countries to make themselves competitive at the expense of the others. Without a common currency, some countries may devalue their home currencies to make their exports cheaper in the international market. Elimination of foreign risks and associated transaction risks promote international trade. Due to use of a common currency, Euro zone exporters realize lower average export prices within and outside the euro zone. Introduction of Euro reduced export prices in the Euro zone by about 1 percent and 5 percent. Consequently, business entities were induced to export different products to Euro zone. Secondly, Euro zone has experienced significant growth in trade because of forming the EMU. According to Rose, common currency can increase trade by 200 percent and eliminate foreign exchange related transaction costs and volatility risks. Trade within the Euro zone has increased at the rate of between 5 percent and 15 percent while trade outside the Euro zone increases at the rate of 5.5 percent since 19996. In 2010, China is the largest trade partner of the Euro zone, overtaking the United States. This trend will be sustained longer if the Euro falls7. This is because average prices of goods traded emerging from the Euro Zone will be relatively lower as compared to those from other regions8. More Euro zone companies are selling their goods abroad because export price volatility dropped and greater price transparency have been realized 9.In addition, single currency increase across-border trade and investment planning security. Third, the Euro has stabilized macroeconomic environment in the Euro zone. Ten years after official launch of the EMU, average annual inflation in the Euro zone fell below 2 percent and is at par with European Central Bank price stability benchmark. As a result, European Central Bank has been praised for achieving so much even though the institution was young and inexperienced. Furthermore, all countries in the Euro zone did not exceeded 3 percent deficit of their GDP in 2007. Compared to other major economies in the world, Euro zone has exhibited greater resilience in the face of high impact macroeconomic shocks such as 9/11 terrorist attack and dot.com bubble. Euro zone countries have experienced increased share in the mutual fund industry of the non-domestic stock holding from 40 percent in 1995 to 79 percent in 2003. Furthermore, the area’s fiscal deficit declined from 2.4 percent of GDP in 2005 to 1.6 percent of GDP in 2003. The labour force has increased its participation to 64.5 percent in 2006 due to increased security and mobility in the Euro zone labour markets10. Germany benefited most by attaining lowest interest rates after 199911. Fourth, job creation has been accelerated in the Euro zone. Sixteen million jobs were created in the Euro zone since the introduction of the Euro. Jobs grew faster in Euro zone as compared to US economy. This is because of the reforms created and implemented through the Lisbon Strategy as well as the coordination, moderation and surveillance framework of the EMU. Fifth, Euro zone has experienced microeconomic stability. Euro zone has been fortified and customers experience increased choices and utility of the products and services. In addition, increased competition and transparency as well as increased market liquidity and economies of scale have promoted convergence in the capital and money markets in the Euro zone. Liberalization has grown, efficient allocations of capital resources have been realized and technological innovation has been improved since EMU inception12. Upon the official launch, interest rates on derivatives and interbank deposits in the Euro zone converged fully on the Eonia and Euribor benchmark rates. The equity markets have integrated faster in the euro zone as compared to other parts of the world. Table 1- The table showing key indicators of macroeconomic environment in the Euro area, non- euro area and the United States of America Period Average Euro Area Denmark, Sweden, UK United States 1989−1998 1999−2008 1989−1998 1999−2008 1989−1998 1999−2008 Real GDP % rate of change 2.2 2.1 2.0 2.7 3.0 2.6 Real GDP per capita % rate of change 1.9 1.6 1.7 2.2 1.8 1.6 Real GDP per capita index, US = 100 73.0 72.0 74.0 76.0 100.0 100.0 Employment % rate of change 0.6 1.3 0.1 0.9 1.5 1.0 Labor productivity % rate of change 1.9 0.8 1.9 1.8 1.5 1.6 Unemployment % of labor force 9.3 8.3 7.9 5.2 5.8 5.0 Inflation % 3.3 2.2 3.4 1.7 3.3 2.8 Fiscal balance % of GDP −4.3 −1.7 −3.6 −0.9 −3.3 −2.5 Gross public debt % of GDP 68.6 68.6 48.7 43.0 67.8 60.7 Long-term interest rate % 8.1 4.4 8.6 4.9 7.1 4.8 Real long-term interest rate % 4.7 2.4 4.2 3.3 4.3 2.4 Source: European Commission 200913 From the above table, employment rate in the euro zone doubled, inflation rate reduced, fiscal balance reduced and interest rates reduced. In general, euro zone is much better after the introduction of the of the EMU. 4.0 Disadvantages of the Euro zone First, multiplicity of countries’ ideologies and pursuits is a big disadvantage to the Euro zone. Each country is different and operates differently14 and different countries pursue goals differently depending on the conditions surrounding them. Perfect agreement can never be achieved because each country is sovereign and do what it consider best even if it is against the spirit of cooperation and collaboration. For example, Germany and France failed to adhere to the guidelines of the Stability and Growth Pact (SGP) by allowing their GDP deficits above 3 percent. In addition, the average public debt of Euro zone countries was 79 percent of the total gross domestic product, which was higher than 60 percent as contained in the SGP15. The conditions and procedures are not followed because Euro zone members pursue own interest first and fail to seriously consider the fiscal standards. For example, excessive government spending and insufficient tax revenues caused Greece’s economic problems while excessive private sector borrowing created larger current account deficit in Spain and Ireland16. This led to eruption of new financial crisis in the EMU in mid 2010. Furthermore, some members are extremely rigid to promote economic growth and development of the other countries. Level of cooperation in the Euro zone depends on power, interest and cooperation of the member countries. Some countries in the Euro zone may fail to act based on shared principles, mutual trust and higher level of understanding. Secondly, the governance structure in the Euro zone is wanting. Most of the fiscal challenges facing the Euro zone members emanates from poor governance. There are a number of procedures that must be followed and conditions that must be met to enable the Euro zone operate optimally. Such conditions such as not allowing deficits above 3 percent of the GDP and not allowing average debt above 60 percent of the total gross domestic product have not been observed by most Euro zone countries. Greece is a country in the Euro zone that continues to find itself in economic problems yet the other members are doing nothing to punish them. Third, Euro zone members relinquished individual monetary and economic policy rights. This is because European Central Bank is an institution mandated by EMU to make monetary and economic policy changes on behalf of the Euro zone members. This means that Euro zone members cannot respond to economic challenges facing them at home. This is not appropriate because different countries in the Euro zone experience difference growth rates, inflation, budget balances, current accounts as well as different competitiveness. Therefore, one fit policy for all is not effective. Other may free ride on the stabilization efforts of others and thereby creating tensions between fiscal policy and overall monetary policy17. Fourth, denial of professional and financial assistance outside the euro zone is another key disadvantage. Once a country is admitted to the EMU, the agreements and treaties prohibit members from seeking professional help and financial help outside the European Central Bank. Greece was prohibited from seeking help from the IMF and its rescue was delayed. 5.0 Conclusion Higher benefits have been realized and many more are perceived. Greece is improving and Germany is growing stronger than ever before. Euro zone is experiencing more stable macro and micro economic environment, trade is increasing, consumer welfare is improving and the area is becoming more transparent and competitive. The challenges that exist in the Euro zone also affect other non-member countries nearly in the same severity. Eurogroup has created a platform for making important decision. The platform will help strengthen policy coordination and implementation in the Euro zone. In addition, it appears that Euro zone countries have started taking the Stability and Growth Pact and the Excessive Deficit Procedure more seriously. Consequently, they are taking fiscal matters seriously. To sum it all, over 300 million people in the Euro zone are better off now than ten years ago. Therefore, Euro zone is there to stay. 6.0 Bibliography ‘The euro did not cause all the euro area’s troubles, but it will make them harder to put right’, The Economist, 11 June, 2009. , 2009, (accessed 26 October 2010). Aslund, A. The Last Shall Be the First: East European Financial Crisis. Peterson Institute, Washington, 2010. Baldwin, R. Gros, D. & Laeven, L. Completing the Eurozone Rescue: What More Needs to be Done? CEPR, London, 2010. Baldwin, R., DiNino, V., Fontagne, L., De Santis, R. & Taglioni, D. Study on the impact of the Euro on Trade and Foreign Direct Investment- April 2008. Directorate – General for Economic and Financial Affairs, Belgium. Dullien, S. & Schwarzer, D. ‘EU Commission proposes revolution in euro area governance’, Euro zone Watch, 29 Sept. 2010, , 2009, (accessed 26 October 2010). Dyson, F. K. The politics of the Euro-zone: stability or breakdown? Oxford University Press, Oxford, 2000. EUROPEAN COMMISSION. Economic Crisis in Europe: Causes, Consequences and Responses. European Economy, London, 2009. FLAM, H., A. FATÁS, S. HOLDEN, T. JAPPELLI, I. MIHOV, M. PAGANO, AND WYPLOSZ. EMU at Ten: Should Denmark, Sweden and the UK Join? SNS Economic Policy Group, Sweden 2009 Great Britain, Parliament. House of Lords & European Union Committee. The Euro. The Stationery Office, 2008. International Monetary Fund. Euro area policies: 2007 Article IV consultation : staff report, staff supplement, public information notice on the Executive Board discussion, and statement by the Executive Director for member countries. International Monetary Fund, Washington, 2007. Liu. , C. H.‘The trillion-dollar failure’, Asia Times, 10 June 2010, , 2009, (accessed 26 October 2010). Nanto, K. D. Global Financial Crisis: Foreign and Trade Policy Effects. DIANE, London, 2009. OECD. OECD Economic Surveys: Poland 2010, OECD Publishing, 2010. Regling, K., Deroose, S., Felke, R., & Kutos,P. The Euro After Its First Decade: Weathering the Financial Storm and Enlarging the Euro Area. Japan, 2010. United Nations Economic Commission for Europe. Forest products annual market review 2006-2007. United Nations Publications, Geneva, 2007 Read More