However, the introduction of the Euro also involves risks for the individual economies; who have given up the ability to change their domestic interest rates and to allow their currency to appreciate or depreciate against other Euro members. This will result in a significant loss of flexibility for these economies, which may prove critical if their economies fail to adjust in line with each other, as Smith (2008) has argued is now happening, with the ‘PIGS’ economies falling far behind their partners. As such, it is possible that the Eurozone will fail to function as an optimal currency area, and business cycles may diverge across countries if they are exposed to different external factors. For example, a recession in Latin America would potentially be more likely to affect Portugal and Spain, as major exporters to Latin America, than Italy and Greece. Such an occurrence could cause a slowdown in the economies of Spain and Portugal, and they would be unable to lower interest rates in an attempt to stimulate their domestic economies. Whilst the common market in theory allows for the free flow of capital and labour to adjust for such issues, businesses may not wish to invest in the slower growing regions without the benefit of lower interest rates. Whilst incentive packages could be used to encourage this investment, this would effectively involve the faster growing countries subsidising their slower growing counterparts; something which they may be unwilling to do (Economist, 1998).
In addition, there is no guarantee that economies will converge, particularly if Germany continues to focus on manufacturing whilst France, for example, begins to specialise more in financial services. Tyson (2000) cites economic data from some of the world’s most developed countries to indicate that closer degrees of economic integration tends to produce more synchronised business cycles. However, the economies will still remain vulnerable to asymmetric economic shocks, particularly in the years immediately after integration. As such, one major drawback of the Euro is that it does not completely remove the chances of major asymmetric shocks, whilst stopping countries from using one of the major policy instruments to counter it: the ability to adjust domestic interest rates (Tyson, 2000).
Barrell and Weale (2003) argue that, not only does the common monetary policy have the potential to be too tight for stuttering economies, but it may also be too loose for rapidly growing economies. This is particularly important as the booming economies in Eastern Europe begin to join the Euro: some of these will have domestic inflation that cannot be controlled by the ECB’s central rate. Whilst this can be countered by national fiscal policies, such as raising taxes or reducing levels of government spending, this may be difficult to do considering that these countries will likely have had to control their spending in order to qualify to join the euro, and may thus be running and unsustainably large fiscal surplus (Barrell and Weale, 2003).
In addition, the fundamental structural changes required to achieve the common market are likely to prevent it from achieving the flexibility required to drive convergence. In particular, Hein and Truger (2005) argue that labour and wages in the European Union are extremely inflexible, and the cultural, language and geographic barriers that remain in Europe make it unlikely that many Europeans will take advantage of the freedom of movement. As such, any region that experiences a decline will likely end up having to wait for the business cycle to adjust in order to recover. Indeed, regions such as southern Italy and eastern Germany have not fully recovered from their economic slumps in spite of the arrival of the Euro, and now have lost the ability to devalue against their potential export markets. A final drawback for the Euro is that the natural barriers to flexibility discussed above are further exacerbated by a significant level of rigidity and job protection in the EU labour laws (Grenier and Tran, 1997). Whilst this is not a drawback to the Euro itself, it further increases the likelihood of some regional and national economies overheating whilst others go into recession.
In conclusion, whilst the Euro has many potential benefits, the lack of flexibility and coherent structural reforms in the Eurozone have led to many of these benefits not being realised, and has served to exacerbate the drawbacks in some areas. In particular, the Euro has failed to drive structural reform in many nations, and the loss of economic flexibility and rigid labour laws make it difficult for the Eurozone economies to attract the labour and capital necessary to maintain economic stability.
Explain what effects might the present rise in the value of the Euro relative to other currencies such as Sterling and the US Dollar have on Eurozone members and their non-Euro trading partners
A variation in the exchange rate of a country is most strongly connected to the strength of its imports and exports. For example, if one Euro goes from being worth one dollar to being worth two dollars, then 100 Euro worth of exports from a Eurozone country will now cost $200 in the US, instead of $100. This will obviously make them more expensive, and will reduce demand for them in the United States and other countries where the dollar is the major currency. However, there are also significant other impacts on market demand, and the fiscal balance issues discussed above can be exacerbated by a currency with a strong value, which can have different effects on the different national economies. These effects will be discussed in this piece.
Gewaltig (2008) demonstrates the scope of the Euro’s rise against the US Dollar, showing that in February 2008 the Euro had increased by 12% year on year against the dollar. This was on the back of 9.1% increase in 2007 and an 8.2% increase in 2006. The most significant change in the value of the Euro versus other countries’ currencies is that it can make exports less competitive in foreign markets, and hence reduce the level of demand for them. Indeed, with many of the world markets trading in dollars, such as the commodity markets, this could have serious impacts on the competitiveness of the Eurozone economies, particularly due to their focus on trade.
Gewaltig (2008) also examined a report from the European Union which indicated that, due to the unique nature and specific characteristics of some of the exports from the EU, such as French wine and German automobiles, the export demand was likely to be relatively insensitive to any such changes in the exchange rates (Gewaltig, 2008). However, the Economist (2008) reported that the several years of steady growth maintained by the EU was likely to result in a downturn in the near future, because of the growing strength of the Euro and the lack of competitiveness of many exports. Indeed, Scott (2007) reported that EADS, the European airspace corporation which own Airbus and many other businesses, specifically targeted the strength of the Euro versus the dollar as a potential business threat. The companies figures showed that for a ten percent rise in the value of the Euro against the dollar, the company would lose one billion Euros in operating profit as a result of the increased competitiveness of Boeing; its main competitor which trades in dollars. As such, it is clear that the growing strength of the Euro is harming the strength of exports from the Eurozone and, according to Wolf (2008), the overall economic growth of the Eurozone versus the UK.
However, another significant impact of the strength of the Euro comes from one of the main causes behind said strength. This is the fact that the European Central Bank has made very strong statements about its commitment to fighting inflation, whilst the US Federal Reserve and the Bank of England have both cut their key lending rates in a bid to boost their economies in the face of the global slowdown (Cohen, 2007). Whilst this has led the Euro to strengthen against other currencies, it has also helped to control some of the internal sources of inflation in the Eurozone economies. This has meant that, whilst trade unions in Britain and the United States have begun demanding higher rates of pay in order to cope with current and likely future inflation due to the interest rate cuts, the Eurozone has maintained somewhat lower inflation expectations. Whilst this has not significantly affected the inflation in the Eurozone economies at the moment, with the majority of the inflation being driven by global commodities, it may help keep the Eurozone inflation rates lower in the future (Economist, 2008).
A further impact of the strength of the Euro is that, whilst exports will become more expensive, imports will become more affordable for precisely the same reason. This is particularly important for commodities such as oil and gas, which are traded on the global markets in dollars. Whilst it can be argued that a significant proportion of the current rise in the price of these commodities is due to the weakness of the dollar, and hence their prices in absolute values will not have changed due to this, there is also increased uncertainty around the supply of these commodities, coupled with rising demand and increased speculation (Wallace, 2008). Whilst this rise in commodity prices has hurt consumers in the Eurozone, they have been less affected than consumers in the UK and US, as the stronger Euro has helped to absorb some of these price rises. In addition, goods imported from the UK and the US into the Eurozone will now be cheaper thanks to the strength of the Euro versus the pound and the dollar.
However, the National Institute Economic Review (2005) argues that this combination of decreasing export strength and increasing import strength is arguably the worst possible for the fiscal balance in the Eurozone. This is because economic growth in the Eurozone is weakening due to a need to attend to the many structural reforms and integration requirements discussed in the previous section. This is compounded by the fact that the Eurozone is a net importer of commodities such as gas, oil and metals; and a net exporter of manufactured goods. The strength of the Euro thus means that the Eurozone economies are less able to export their finished manufactured goods to key markets, at the same time as the raw materials they use to create these manufactured goods are rising. In addition, the fact that the Euro has performed best against the pound and dollar means that UK and US exports to the Eurozone are growing in competitiveness versus domestic goods. With the National Institute Economic Review arguing that Eurozone domestic demand is likely to continue to grow slowly, and consumption may decline, the Eurozone is arguably entering a very difficult period. This will be exacerbated by the fact that governments are unable to adjust their own interest rates, and their public sector expenditure is constrained due to the Stability and Growth Pact which is part of Euro membership.
However, it is important to note that, paradoxically, some of the Eurozone nations have benefitted from this, particularly the weaker nations. OCED Observer (2004a) presents predictions for the Italian economic, which argue that the growth in the level of exports and investment activity will tend to rise due to the strength of the Euro. This is because Italy has been forced to make several competition reforms to key sectors of its economy, which has helped to make Italy more competitive and innovative relative to its Eurozone partners. This additional competitiveness is now coming to the fore, whilst other nations struggle. In contrast, in another article, OECD Observer (2004b) points out that Ireland’s strong growth in previous years has led to excess demand, which has begun pushing up inflation rates. As such, the Irish economy is more vulnerable to the strength of the Euro, as it has not focused on driving efficiency and competitiveness during its rapid growth. Indeed, the strong Euro combined with the lack of flexibility in the Irish economy is arguably one of the reasons why Ireland has gone from being the ‘Celtic Tiger’, to arguably being included in Smith’s (2008) underperforming ‘PIGS’.
In conclusion, the unique nature of the Euro, as a single currency operating across different national economies with different national legislation, means that the impact of a strong exchange rate is somewhat different than the impact on other countries. Whilst the Eurozone is experiencing the usual loss of competitiveness of its exports, and increasing competitiveness of imports, the diverse nature of the national economies is helping to mitigate this in some areas. In addition, the strength of the Euro has assisted structural reforms in countries such as Italy, whilst exposing structural weakness in nations such as Ireland, thus having a dynamic impact on the distribution of wealth and competitiveness inside the Eurozone.
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