Introduction
With the desire of achieving economic growth and sustainability, many governments of the world always formulate and implement such strategies that will ensure that this long-term goal is achieved. Economic integration is one of the main economic strategies that many states all over the world have come up with. In 1957, several European states came together to create a common market for their goods and services.
This led to the birth of the European Union (Drazen, 2011). With a common market, it became possible for these states to gain a maximum profit from the alliance as a result of the elimination of trade restrictions that had been previously imposed.
However, for the member states to fully benefit from such an alliance, it was essential to come up with favourable monetary policies. One of the suggestions with regard to this was for the zone to have a common currency. This had been proposed in the 1992 Maastricht Treaty and led to the adoption of the euro several years later (Dooley, 2011).
By 1999, the euro had been introduced. The euro is the official currency of the member states of the European Union (with the exception of Britain and Denmark). The introduction of a common currency among member states was a huge step towards economic integration in the euro zone. At the present moment, there are17 states that use the euro as their official currency.
This includes over 330 million individuals from the member states and surrounding nations. Its use has spread to other nations outside the European Union that want to enjoy the success that comes with the currency. However, the euro has also been facing a number of problems and challenges.
The European Sovereign Debt Crisis is, perhaps, the major challenge that the currency has faced so far. This paper will, therefore, focus on the euro, its introduction into the market and the positive and negative impacts that it had on the euro zone.
The Euro
All the member states of the European Union are a part of the European Monetary Union (EMU) (Hatzius, 2011). This shows an advanced level of economic integration under one market.
These states thus have similar economic and fiscal policies that aim at improving their economic status and that of the zone at large. For those states that have the minimum monetary condition, their integration is much more sophisticated since they share the same monetary policies and use a single official currency; the euro.
The euro was introduced as the official currency of the European Union. At that point, it became the official currency of 11 member states (Drazen, 2011). It thus replaced currencies, such as the deutschmark and the French franc (Drazen, 2011).
However, this transition was not absolute as it was brought into in two faces. First, the euro was introduced as virtual money (in a non-physical form). Here, it was used for cashless payments (such as electronic money transfers, debit card payment, credit card payment and so on). It was also used in accounting transactions. However, the official currency of member states was still in use.
These currencies were, however, considered as subunits of the euro (Drazen, 2011). The national currencies were used for cash payments. However, on January 1, 2002, the euro first appeared in the form of coins and notes. It should be noted that the euro is not the official currency of all the member states within the euro zone.
Denmark and Britain, for instance, still use their national currencies after agreeing to an ‘opt out’ clause. Consequently, there are those countries within the alliance that have not met the requirements of adopting the currency, for instant, Sweden. Once these countries meet these requirements, their national currencies will be replaced by the euro.
When the euro came into existence, an independent body was commissioned to control and regulate it. This body is the European Central Bank (ECB) (Drazen, 2011). The ECB was specifically created to control the monetary policies of the European Union. This step was adopted after the central banks of member states adopted the euro as their official currency.
The ECB and the national central banks of the member states are collectively referred to as the Eurosystem (Dooley, 2011). To have an independent body monitoring the monetary policies of the zone was essential. This is because this body would not give in to national pressure from respective governments. However, the fiscal policies of the member states are still under the control of their respective governments.
However, while formulating these policies, the member states have to follow the specific rules and guidelines of the alliance (Stability and growth pact) in order to avoid infringing the benefits that other states may accrue and to ensure that the zone achieves its short-term and long-term goals.
The Euro, as the official currency of the euro zone, has played a critical role in achieving economic and political stability among member states. At the same time, it has encouraged the formulation of sound policies and frameworks that have led to a desired public expenditure among the member states. The European Union was established to create a common market among member states.
Thus, it was only logical that a single currency should be used to enhance trade within the region. Adopting the euro led to an increase in price transparency and the elimination of currency exchange costs. This caused an increase in international trade that resulted in the development of a strong economy in the region. Due to this fact, the euro zone has become stable over the years.
This stability, as a result of having a common market and currency, has made the zone to be immune to economic crisis that have arisen outside the zone. The raging prices of oil and its related products and the turbulence that was experienced in the currency markets had minimal impacts on the euro zone (Dooley, 2011).
Optimal Currency Area
The euro zone can be considered as an optimal currency area. In economics, an optimal currency area is a vast region under a single currency (Hatzius, 2011). It has always been advocated that such regions maximize their economic efficiency by having a single currency.
To explain best the situation of the European Union and the Euro, Robert Mundell asserted that the European Union benefited from their alliance as a result of adopting a single currency (Hatzius, 2011).
To defend his arguments, Mundell presented the international risk sharing model that stated that if a currency is under proper management, the larger the geographical region it covers the better. This is why, such a region is immune to asymmetric shocks that arise from outside the region as a result of the integration of capital markets under a common currency.
Ease of Transactions
The Euro being a single currency has improved the ease at which transaction within the region is performed. The presence of a common market eliminates the trade barriers between member states and hence encouraging international trade. However, since the European Union adopted the Euro, transactions have become much easier.
The main impact that the euro had was to eliminate the cost of exchanging currencies among the member states. The fact that a single currency is now in circulation has given individuals, businesses and large corporations a chance to venture into diversified businesses; some of which were considered unprofitable due to the costs that were incurred as a result of exchanging money from one currency to another.
This has also eliminated the cost of non-cash payments that accrued to non-domestic members. The euro also eliminated the exchange risk that individuals and businesses experienced while investing outside their borders. Due to the absence of this risk, more foreign investments have been made since 1999 within the euro zone (Dooley, 2011). These factors have also improved the banking sector within the euro zone.
Price Stability
The presence of the euro has also led to the stability of prices of goods and services. The euro has reduced the level of price disintegration as a result of the law of one price. The presence of different price level for a specific commodity normally result to arbitrage.
Sellers will normally look for markets that offer the best price for their products in a bid of getting the highest profits. The presence of a single currency within the European Union has eliminated this situation. As a result, there is stability in the cost of goods and services even across borders.
Economic Stability
The main aim of modern economies is to maintain a stable growth in the short run and in the long run. Inflation is one of the main factors that act as a barrier of many economies realising this goal. Inflation also acts as a form of tax thus discouraging individuals from investing (Dooley, 2011).
The monetary policies that are present in many countries make it virtually impossible to control inflation. This is due to that fact that their government has a great influence that affects the decisions that their central banks make concerning the monetary policies that they come up with.
However, the European Central Bank (ECB) has eliminated the presence of a single currency, the euro, as well as independent monetary body. Due to this fact, the ECB cannot give in to pressures from national governments of the member states while formulating its policies.
It is regarding the fact that the ECB has always been formulating monetary policies that have kept inflation at a low level (Hatzius, 2011). This is the main role of the ECB. Unlike the Federal Reserve in the US, the ECB has no mandate of the fiscal policies of the member states. This doctrine is under the jurisdiction of the central banks of the member states.
As a result of the sound monetary policies that have been advanced by the ECB, national and corporate bonds of the member states have become more liquid than they were when the member states used their national currencies (Frankel, 2011).
Increased liquidity lowers the nominal interest rates and gives the economy a stronger base regarding its ability of paying debts. As a result, debts in the euro zone were issued below the nominal interest rate (Dooley, 2011). In addition, the increased liquidity makes the euro zone economy to stand a better chance of paying its debt if inflation occurs in future (Dooley, 2011).
Such conditions have made the economy of the European Union to grow tremendously. Trade, for instance, has risen to about 10% since the introduction of the Euro. Consequently, there has been an increase in foreign direct investments to about 20% within the first four years of the euro introduction.
This has come about since it has been much easier for individuals to access money. Additionally, much of the investments came from countries that had a weaker currency before the introduction to the euro. The graph below shows the investment rates of the member states since 2009 (Frankel, 2011).
There have been also massive integrations in the financial sector, especially in the banking industry. These factors have made trade to become much easier and more profitable, fostered a desired political stability and sustained economic growth among the member states. The euro has grown to be one of the worlds strongest currency. The graph below shows the euro’s exchange rate against the dollar since 1999 (Frankel, 2011).
Therefore, the presence of a single currency within the European Union has led to the development of trade and commerce within the region. It has resulted to an increase in GDP among the member states, boosted the status of all the economic sectors, increased employment and finally increased the liquidity of the currency. The euro has thus made the European Union one of the worlds most stable economy.
Challenges Facing the Euro
According to the international risk-sharing model that was presented by Mundell, the larger the region under a single currency is, the more it benefits. However, when a crisis occurs, all the member states will be affected.
This is why, in most cases, the fact that the official currency will be affected may lead to its devaluation (Gourinchas, 2011). Before countries became the member states, they had had to fulfil the convergence criteria. In addition, there were set rules and guidelines that had to be adhered to.
However, the strictness of these rules and guidelines applied among various member states was different. This may have led to the emergence of the European sovereign debt crisis that is progressing at the present moment.
According to the Maastricht Treaty, member states of the euro zone had to maintain low deficit and debt levels. However, the countries like Italy and Greece were able to find the way to evade these rules. But it resulted in massive financial and fiscal deficits. On the other hand, there are some countries that may have benefited much more than the others from the euro zone alliance leading to trade imbalances.
Germany, for instance, had a surplus balance of payments while France, Spain and Italy had deficits (Gourinchas, 2011). Finally, due to the fact that the member states do not have power over their monetary policies within the euro zone, they are thus unable to devalue the value of their currency to solve the financial crisis that they may be facing.
However, within the same alliance, countries such as Britain and Denmark are able to print more money in an event of financial crisis. This act has been boosting its exports. This monetary inflexibility is an important contributor to the financial crisis that the euro zone is facing.
In addition, the period between the introduction of the euro up to 2007 was characterized by easy credit availability, low interest premiums, availability of liquidity and soaring of assets. The crisis grew from the perspective of liquidity shortage in financial institutions to massive national debts. As a result, the GDP of the EU is projected to decline to as low as 4%; this is the lowest rate since its introduction (Gourinchas, 2011).
Conclusion
The European Union has been successful since its creation. The introduction of the euro as the sole currency of the region was a superb idea since it increased the process of trade and commerce among the member states. However, as a result of poor policies and rules, the region is facing a monetary crisis now.
For the region to continue enjoying the benefits of having a monetary union, it is essential for it to come up with monetary policies that will ensure that individual states and the union at large prosper from the alliance.
References
Dooley, M 2011, ‘The Revised Bretton Woods System’, International Journal of Finance and Economics, vol. 9, no. 1, pp. 307-313.
Drazen, A 2011, ‘Do crises induce reform?: Simple empirical tests of conventional wisdom’, Economics and Politics, vol. 13, no. 2, pp. 129-157.
Frankel, J 2011, ‘Assessing euro zone exchange rate regime’, Economic Policy, vol. 4, no. 15, pp. 576-627.
Gourinchas, P 2011, ‘International Financial Adjustment’, Journal of Political Economy, vol. 115, no. 4, pp. 665-702.
Hatzius, J 2011, ‘Beyond leveraged losses: The balance sheet effects of the home price downturn’, Brookings Papers on Economic Activity, vol. 6, no. 2, pp. 195-227.