Monetary Integration in the European Union - Essay Example

Evaluation of the success of European monetary union to It is one decade since the euro was first launched in the twelve European countries that formed part of the European Union. The 1st of January 2002 is the date that not only left a mark in the European history, but also in the entire world. That was because the launch of a common currency represented the finalization of an ambitious idea that had been launched in Maastricht a decade earlier. Today, it is estimated that over 300 European citizens use the euro as their sole currency (Chang, 2009 p. 3). However, the number is set to go up in the coming years owing to the fact that the European Union has been expanded to include a total of 27 countries. In the years that it has been in existence, the euro has widely grown to be recognized as an international currency, and thus, it has enjoyed benefits of the world’s stable market and endured the times of instability. The first idea that gave birth to embryo of the European Monetary Union can be traced back to R. Mundell’s theory of optimum currency areas of 1961 and that of R. McKinnon of 1963. However, it was until 1978 that an idea on the European Monetary System was proposed (Overturf, 1997 p. 14). The proposed European Monetary System (EMS) had various components that included; financial support mechanism (FSM), European Monetary Cooperation Fund (EMCF), exchange rate mechanism (ERM), and the European currency union (UCU). From the inception, the implementation of the European monetary Union in itself was a major triumph. As the ambitious program began to be operational, the countries that were under the union realized many benefits and costs, and in some instances, experienced serious flaws. In a real sense, unification of the currency helped to enhance the condition of the single market since it permitted all transactions to be conducted in one single currency. In that case, application of a single currency helped to improve competition among the member countries and also made the entire European economy to be more compatible with the global market. Because competition among the member states was enhanced, the consumers benefitted immensely because they had a wider range of choice, better quality, and reduced prices. The use of a single currency also helped to attract foreign investment, particularly in areas that were least developed. The use of a single currency within the European countries has ensured stability and positive inflation in most of the years that it has been under operation. The concept of money, as a means of measurement, can assist in comprehending why stability of money was made a chief objective in the European monetary policy. Among economists, it is a common knowledge that rapid depreciation of currency, that is, internally via inflation and externally via devaluation, can detrimentally impact on the economy and the currency under utility. Such a scenario can afford a government a chance to defraud those institutions that lent money to them. It has also been argued in many instances that zero rate of inflation is not a wise target (Overturf, 1997 p. 19). That is because alteration in the quality of goods and the emergence of new products makes price indexes an inaccurate science. Many critics have tried to blame the European Central Bank (ECB) of striving to attain super stability in exchange for high unemployment and low growth. The truth is that the underlying conditions have not been that way. Ideally, the Bank has sustained a stable inflation rate at approximately 2%. It has also a common short-term nominal interest rate at the range of 2-4% and enhanced money supply within an annual range between 4% and 9%. Such monetary policies have been instrumental in pursuing long-term price stability. In that respect, the most fundamental indicator is the level of inflationary expectation rather than level of current inflation (Cini, 2003 p. 29). During the 1990s, one of the strongest statements in support of the European Monetary Union was that it would insulate European countries from global financial storms. During that time, the market could record a foreign exchange turnover of close to $1000 billion on a daily basis. With free capital movements in the region, there was a huge danger of speculative force on individual national currencies (Gower & Thomson, 2002 p.7). The danger was manifest when the European Monetary System encountered a disaster between 1992 and 1993. From the lessons learnt after the crisis, it was evident that use of fixed exchange rate system alone was not adequate. It is clear that the European Monetary Union has succeeded in achieving its first objective. Since it began to operate, there has never been sudden decrease in value of the D-Mark, or destabilization of the Italian Lira or French Franc. That is because the different currencies no longer exist. The European Central Bank deserves credit because it has been able to copy the Federal policy of benign neglect as used in the United States. The Euro has managed to play a less external parity as compared to the various currencies that it eliminated. The introduction of the euro quickly transformed the European financial markets. For instance, government bonds were rapidly integrated into the bond market. A notable record of the growth of the corporate market was that of 1999 when an impressive rise of 300% was recorded in euro-denominated issuances. From 1999, the proportion that the euro acquired in the total outstanding international debt securities has been steadily rising from 21% to 31%. It is estimated that approximately a quarter of the entire foreign exchange reserves are currently in Euros (Chang, 1999 p. 18). Although the dollar is still regarded as the world’s most vital currency, the euro has grown favorable to take the second place, and the trend is expected to increase in the near future. The aspect of the European Monetary Union that has generated the worst publicity is the stability and growth pact. Contrary to the popular belief, the aspect was not part of the original plan that was created at Maastricht Treaty. The stability and growth pact was introduced in 1997 after a council of finance ministers negotiated and adopted the pact. In some way, the pact contradicted or tried to alter the provisions of the original treaty, which posed a danger of rise in cases of indiscipline in the financial market. Where the original treaty called for national budgets to maintain a normal deficit below 3% of GDP, the pact advocated for national budgets to be close to equilibrium, or surplus over the economic cycle (Gower & Thomson, 2002 p. 47). Recently, five European countries were subjects of the excessive deficit procedure. Only Greece, whose deficit ratio in 2004 was 6%, had a deficit ratio that was marginally above 3%. Budget balance and Public Debt, as % of GDP, 2004 Country Budget surplus (+)/deficit(-) Public debt Belgium 0.0 96.2 Germany - 3.7 66.4 Greece - 6.6 109.3 Spain - 0.1 46.9 France - 3.7 65.1 Ireland + 1.4 29.8 Italy - 3.2 106.5 Luxembourg - 1.2 6.6 Netherlands - 2.1 53.1 Austria - 1.0 64.3 Portugal - 3.0 59.4 Finland +2.1 45.1 € area - 2.7 70.2 Source: ECB Bulletin, February 2006 From the table, it can be observed that average national deficit ratio for the entire Euro region was 2.7% in 2004. Additionally, the average public debt was 70% of the GDP. This implied that the public debt had surpassed the target which stood at 60%. However, it is essential to remember that five countries were below the target level, and four other countries were within the allowable range. Greece and Italy were the only countries that had its public debt over 100% of their GDP. The treaty that gave birth to the European Monetary Union points out that, what really matters is maintenance of the government financial position. What is usually used to indicate sustainability of the government financial position is the yield spreads on various long-term government bonds. After the exchange risks came to a stand still in 1999, all spreads became narrow. However, during the early 2005, the yield spreads of Portugal, Italy, and Greece widened, and thus, exposing their budgetary imbalances. Since then, their yield spreads have continually narrowed. The notion of one size fits all has always exposed the European Monetary union to criticisms. Many analysts have stated that one size fits all interest rate is not good. When nominal interest rates are made uniform, and inflation rates vary from one region to another, then the real interest rate will also change accordingly. For countries that experience high rates of inflation, the nominal rate may be seen as too low, while in those countries where inflation rate is too low, the nominal rate may be too high. Many have also argued that the strategy that was applied by the European monetary Union promotes convergence. Proponents of such arguments claim that as production factors and markets integrate, variation in inflation decreases and economic cycles will finally be aligned. Since the beginning of the monetary union, such convergence has only taken place twice, that is, in 1998 during the period of qualification, and in 2002 (Cini, 2003 p. 31). What has been really happening in the economic block is that countries with comparatively low standards of living tend to experience high levels of inflation as compared to their counterparts with higher standards of living. Ever since a single currency was introduced within the member countries, the goal of stimulation of economic growth has never been realized. In fact, research reveals that the introduction of a single currency has contributed to increase in the levels of unemployment. It was believed that the introduction of a single currency would help to enhance price transparency, reduce transaction costs, and eliminate exchange risks. For that reason, the market was expected to experience internal competition and increased trade. The single currency created a forecast effect. Between 1998 and 2001, trade between Euro area countries increased by up to 20% relative to Gross Domestic Product (Szász, 1999 p. 52). Statistics from the stock market also indicates that business within the region is good. For instance the Dow Jones EURO STOXX index indicated that there was a rise in 2003, which was subsequently followed by a 10% gain in 2004. The European Central Bank attributed the results to considerable decline in the stock market volatility, strong growth of dividends and earnings, and lower long-term interest rates. Despite the positive information from the stock market, the economic growth statistics appear poor. In the year 2000, the euro area growth rate was at 4%. However, in 2003, it fell to 0.6%, and then in 2004, it recovered to 2.5%. In 2005, the economic growth also declined slightly. Modest recovery was realized in both 2006 and 2007 (Chang, 2009 p. 89). For several years, unemployment level within the Euro area has remained well over 8%. Various national governments have tried various strategies without attaining positive results. For instance, in France the strategy of the 35-hour week has been applied in an attempt to reduce the figures. Considering employment figures solely can produce a deceptive picture. When unemployment and employment figures are studied concurrently, a different picture emerges. Many economists within the Euro region have indicated that the rate of employment has been increasing faster than the rate at which unemployment levels have been falling. The reforms that have been undertaken within the Euro area have encouraged previously discouraged workers to return to the workforce. So far, the introduction of a single currency within the Euro area has led to numerous benefits for those countries that were willing to carry out national reforms, and prepare adequately to complete with other nations. Some countries that have been slow in effecting necessary changes, for instance Greece, have experienced various economic challenges. Notably, Greece has been experiencing low economic growth. This implies that during the beginning of the sovereign debt crisis, they required financial assistance to finance governmental operations. In that case, they had to sell government bonds. During the time when the bonds matured, they were obliged to pay their bondholders an interest in addition to the face value of the bonds. Because of low economic growth, the country’s cash reserves or tax revenues were too low, and thus, the country experienced a situation where they had to pay their creditors more that they could afford. In other words, they had difficulties in raising funds that was required to make bond payments. Additionally, during the time when there was a financial crisis, the interest rates were high, and thereby, forcing the country to experience more difficulties in meeting demands of their creditors. The country did not have a chance of borrowing more money so that it could be in a position to repay its current debts. The country had only three options left; defaulting on its debt, monetizing its debt, or renegotiating its debt. Such a situation was attributed to the poor monetary policies of the European monetary union, and the country’s failure to undertake its domestic reforms so that it could position itself to benefit from the numerous opportunities for growth within the Euro area. To avert the occurrence of such incidences in the future, it is important that the European Central bank should create policies that can guide national governments on how they can streamline their domestic markets so as to enhance economic development. It is essential to note that the European Monetary Union is good; however, there are a few reforms that need to be undertaken to reduce risks that might occur during times of financial crisis. The European Monetary Union has a great potential that can only be achieved if the system is carefully evaluated and necessary changes effected. References Chang, M. 2009. Monetary integration in the European Union, Palgrave Macmillan, Basingstoke. Cini, M. 2003. European Union politics, Oxford University Press, Oxford. Gower, J., & Thomson, I. 2002. The European Union handbook (2nd ed.), Fitzroy Dearborn. London. Overturf, S. F. 1997. Money and European union, St. Martins Press, New York. Szász, A. 1999. The road to European monetary union, Macmillan, Hound mills, Basingstoke, Hampshire. Read More