Economic and monetary union

Identify and discuss the costs and benefits of joining the Economic and Monetary Union (EMU)? Do the benefits outweigh the costs?

Abstract:

"EMU is seen as a mean to recover some influence over European monetary affairs." (Franois Mitterrand, 1992) The idea of an EMU appeared in the Werner Report in the 1970s in which France has played a major role. Indeed, the French social democratic president Franois Mitterrand wanted the European Union and its member-states to have a stronger influence in the world compare to the US dollar which has been widely used as the standard measurement for all currencies. This has led the president of the European Commission at time, Jacques Delors, to turn the idea into a concrete proposal. Advocators of EMU stress that it is essential to create a stronger European Union with greater economic, political and social cohesion; however others do not support this stage of the European Union's construction such the United-Kingdom, Denmark and Sweden.

In Europe, the existence of different national currencies was considered as the remaining barriers for a barrier-free single market and the influence of the dollar pressed the European Union (EU) to form an Economic and Monetary Union (EMU). The EMU is a type of trade block involving a single market and a common currency. At the European scale, it involves a single European market within its borders and the adoption of the Euro.

Economists usually refer to the EMU as an economic trade off between perceived benefits and cost of joining the area[1]. There a diverging views on the extent of these costs and benefits, and therefore, especially on the question whether to join the EMU or not. The aim of this paper is to analyse the key issues surrounding the EMU, positively as well as negatively. The case for or against the EMU requires a careful analysis of the economic pros and cons at both national and firms level.

Only a more integrated Europe will be able to exercise leadership on the global issues facing the world economy and compete with the US. Indeed, there are many benefits that a country will have by entering EMU. Recently, the euro has gained a lot of influence since many European nations have adopted it. The growing importance of the euro in international trades and the increasing trade activities which result from adopting the currency clearly shows that benefits will outweigh costs. Indeed, for most countries international trade is fundamental in order to have a strong economy. However, the "antis-EMU" advocate that the process will submerge the individuality of the European nations in an "unwieldy federation, hobbled by bureaucracy, commanding little popular support and imposing a crippling burden of regulatory and other costs on Europe's economies" (David Currie, 1997, pp.14) They believe that an organized Europe will be negative for most member states as it will also "reduce the volume of trade and would certainly increase the level of unemployment" (Martin Feldstein, February 20, 2008).

In order to join the EMU, a country must correspond to the Maastricht Convergence Criteria: price stability, sustainable public finances, exchange rate stability and durable convergence. The term "convergence" refers to the process of unifying technological and non-rival domains, preparing late countries in terms of structure and institutions to catch with those at the forefront. The fulfilment of these criteria should be durable. One of the first obvious benefits is that the implementation of those criteria represents a factor of macroeconomic stabilisation and sustainable economic growth for both EMU countries and future members. However, the convergence requirements are also a clear example of conflict because they are considered as lacking economic rationale and imposing unnecessary pain. Many economists have attacked the convergence criteria, responsible of provoking instability and serving no other purpose except to delay. (De Grauwe, 1993) The convergence criteria and EMU itself seek to guard against "unsustainable budgetary policies in a member state" because these are seen to lead to either "default or debt monetisation" which would "be a major threat to the overall monetary stability" (European Economy, 1990:100) Furthermore, the convergence criteria makes clear that "fiscal discipline is defined as the avoidance of an unsustainable build-up of public debt" (Emerson, 1992, pp.107) and the transition to EMU for a country will "amplify the domestic effectiveness of national fiscal policy for stabilisation purposes" (Emerson, 1992, pp.115)

Our aim is to understand the incentives of the players in the EMU, and a natural starting point is to assess economic costs and benefits of a single currency for a country like France for example. More or less, there are microeconomic benefits versus macroeconomic costs.

Transaction costs and stable environment

One of the most obvious benefits is the resulting ease of transactions across the European Union. Countries are using one currency and as a matter of fact, the elimination of exchange rate fluctuation helped to eliminate transaction costs in intra-EU trade. Firms and business are both saving time and money. For example, an estimated $30 billion[2] a year is spent on foreign exchange transactions. The transactions involve the change from one currency to another but also from accounting systems. Additionally, joining the EMU eliminates the possibility of exchange-rate variation with the EMU zone. If exchange rates move irregularly and unsystematically in response to arbitrary speculation, exchange volatility imposes a macroeconomic cost. Thus, its elimination represents a real advantage as it provides a more stable environment for trade within the euro zone by lowering risks and uncertainties as the economy is more flexible and resources more mobile.

Fiscal power of member-states

However, joining EMU severely limits the fiscal power of member-states. While they maintain formal responsibility for fiscal policy, member-states will have to show fiscal rectitude to avoid punishment. Indeed, fiscal policy remains the only macro-economic tool that is available to governments. At the same time, the union has the power of coordination and surveillance, and the ability to recommend modifications of fiscal policy and to apply sanctions against governments that have no taken the recommended steps.

A single currency and its effect on public support

As we already mentioned earlier, a member-state joining the EMU will have to adopt a common currency: the euro. The adoption of the euro will clearly affect the country's sovereignty. Additionally, adopting a new currency is not always the easiest thing to do. Indeed, currencies such as the "Francs" or the "Deutsch Mark" have symbolized economic prosperity, especially due to the fact that people had trust in them. Moreover, the "Franc" was the French national currency since 1795 and has remained for two hundred and four years. The Deutsch Mark had the reputation as one of the world's most stable currencies. For a country like France or Germany, the change of their currencies was a memorable step. Moreover, the adoption of the euro for a member-state had a real impact on consumers' purchasing power. For example, in France the switch from "Francs" to the "Euros" had a major impact on our purchasing power. Twenty euro is the equivalent of approximately a 120FR and this was a large amount before the introduction of the new currency.

Monetary policy and the European Central Bank

Despite affecting a fundamental aspect of a country's sovereignty, member-states must abandon monetary policy. Additionally, members are deprived from revenue of seigniorage which is the net revenue derived from the issuing of currency. This loss mainly affects high-inflation rate countries such as Greece or Spain for example. Monetary policy is not anymore at the national level but depends on a supranational authority, the European Central Bank, headquartered in Frankfurt, Germany. Established in 1998, the ECB is responsible for monetary policy covering the sixteen member States of the Euro zone. Granting monetary control to the ECB means that National governments are giving monetary policy instrument such as regulating exchange rate and interest rate, and this is likely to involve a cost. This cost will occur during recession or inflationary boom, when a country will be unable to raise or lower interest rates independently of other countries within the EMU.

Effects on firms and businesses

Another benefit is the increase in attractive opportunities for foreign investors and these effects are unevenly spread across firms and businesses. Thus, larger firms will benefit more from EMU. For example, strong domestic enterprises will benefit from a greater degree of internationalisation of their markets. It will be especially helpful to small and medium sized enterprises which may not be able to reap sizeable economies of scale. However, firms and businesses are the first one to lose from joining the EMU. For example, travel agents and banks that are losing commission on currency exchanges and European currency traders will no longer be able to exert this business. Moreover, the single currency may lead to the "Europeanising" (Brown, B.2004, pp. 57-60.) of labour markets within the EMU zone. Consequently, it would be much easier to compare wages across the zone, especially in sectors where trade unions wield bargaining power. This will lead to an increase of wages and could engender major problem to companies outsourcing in low wages countries such as in Eastern Europe. The single currency will remove just the elements of labour-market flexibility.

Price transparency and price convergence

Nevertheless, joining the EMU will foster competition as there is greater price transparency across countries. Indeed, a single currency makes easier to show how prices differ between countries. It has been found that "the prices of goods differ considerably in different countries and continents due to the differences in currency." (McCallum, 1995, pp24-25) As an example, before EMU, a customer living in France was able to buy a high value-added car cheaper when going in Germany. Hence, this leads to lower prices in the short to medium run because consumers can buy from the cheapest source and thus, drive prices down as companies are running on pressure. Indeed, "The formation of the euro zone and the SM of almost 300 million consumers will inevitably sharpen competitive pressures throughout Europe". (Spanos et Al., Greek, pp.638) The subsequent enhancement of competition will increase economic efficiency and should cause price convergence. (Spanos et Al., Greek, pp.639) Consequently, the EMU provides information to its members and thus, enables them to make wiser decisions.

"One fit all" policy problem:

Moreover, other problems of joining the European Economic and Monetary Union will occur over the medium to long term. Indeed, the concern is that whether the states are sufficiently similar for them to co-exist with a common currency. For example, not all states are at the same stage of the trade cycle which represents a periodic fluctuation in the rate of economic activity as measured by levels of prices, production and employment. As an example, the UK is the world's fourth largest economy and the second largest in the EU. The City of London represents Europe's major European financial centre. The case of the UK has specific arguments: the UK has a lower level of intra-EU trade, one of the highest percentages of home owners and is affected differently by oil price movements due to different arrangements. It is then weaker and more vulnerable to external shocks which are unexpected shocks that do not affect every nation equally. (D. Johnson, C. Turner, 2nd edition, p180-183) Hence, if the UK joins the euro, they will have to increase their exchange risks because the euro is turning around the dollar. The pound for example is neutral compared to the dollar and the euro. Consequently, the inappropriateness of one monetary policy for so many states is a major cost of joining the EMU. The case against the UK's entry in EMU depends also on other factors such as the recession the country is undergoing and the influence of the United-States.

The case of Greece is a good example to show how benefits can outweigh the costs. Indeed, Greece has recently entered the EMU and thus, represents a good example for a number of candidate economies such as Poland for example. Hence, it is an example of an economy in transition that has made a lot of progress in order to fulfil the macroeconomic convergence. A study of Greek firms has been conducted by Spanos (Business strategy analyst at Athens University) which helps to understand how firms react when entering the EMU and found that leading Greek firms "appear fully aware of the dramatic changes they will have to address in the near future...In line with recent empirical evidence, the findings presented here are encouraging in that they suggest a strong learning effect that has presumably led Greek management towards convergence." (Spanos et Al, pp.646) We understand that both EU membership and the panorama of competing in the EMU have acted as major catalysts. In short, the EMU has contributed toward the development of western-type of management style. Additionally, Greek firms have new challenges to overcome and this requires new competitive strategies, organizational structures, and management processes. Consequently, Greek firm's strategy has shifted toward offer better quality products and services, and a tighter cost control.

Trade theories are examples of why benefits outweigh costs. (Aiginger, K. et al, 1999, pp.3) The traditional theory was described by Ricardo in 1817; a country can achieve a "comparative advantage" resulting from differences in productivity or endowments between countries and regions. Consequently, trade liberalization and economic integration will result in production re-location and increasing specialization according to comparative advantages.

Additionally, Mundell (1961) McKinnon (1963) and Kenen (1969) identified the reasons why a country should or should not enter a monetary union. If for every member-state benefits outweigh costs then the currency area is optimal. An "optimum currency area" (OCA) considers the premise that "when an external shock hits the economy, it is easier to adjust the exchange rate than domestic prices or wages." (A. Belke and D. Gros, (1997). pp. 3/50) Indeed, this approach assesses what a country loses by giving up the exchange rate as an adjustment instrument. According to Krugman, the benefits of EMU increase and costs decrease as the level of integration intensifies. (Krugman, 1990)

To conclude, according to Martin Feldstein, EMU is seen by France as an opportunity to be a "co-manager" of Europe as an equal of Germany. Furthermore, it has been assumed that economic integration among the European countries will lead to convergence while reducing asymmetric shocks. However, classical theories assess that integration results in more specialization due to comparative advantage. Hence, core economies (France and Germany) may benefit at the expense of less efficient economies such as Eastern member-states. Furthermore, with a Single Market, firms will have to expand in size in order to compete. Such large firms are mostly located in core economies of the EU. However, Greece case study showed that EMU has contributed to the development of firms in offering higher quality products and services. We can then conclude that if a country joins EMU, benefits will clearly outweigh costs.

References:

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