Problems of having Euro as a Common currency for Eurozone

by Sakshi Rai


Posted on September 29, 2020


The 1980’s saw Europe face stagnation and bad statistics. Unemployment had spiked two fold. Potential growth rates had plummeted and the US was heavily burdening European exports with economic restrictions. It was against this backdrop that the idea of a restriction free common market emerged with the aim of boosting trade and strengthening economic growth. At the same time, they also wanted to prevent the practice of devaluation that was a frequent among competing European economies at that time. Euro was initially a success because it was able to bring about substantial price stability in the eurozone. It was also able to reduce the transaction cost for tourists and businesses because it saved them from the hassles of currency exchange from region to region. Now, the same currency could be used in 19 different European countries facilitating ease of mobility for these entities. However, the hindsight benefits came at the cost of major structural inadequacies. They failed to recognize the dichotomy that existed in European economies back then and even now. On one hand were the northern and central European countries like Germany and the Netherlands with competitive industries, top ranking in global business indices, highly fluid market and existence of responsible power structures. On the other hand existed the Southern European countries (Spain, Portugal and Greece) which didn’t enjoy the same level of competitiveness. These countries had historically attempted to compete through currency devaluation. Also, the government in these countries hadn’t implemented any structural reform that could’ve culminated in better competitive spirited economies. This reliance on devaluation ended with the introduction of Euro as the common currency, boosting domestic demands through strong imbalances in their payment balance. These economies overburdened themselves with loans, aggravated by the real estate bubble and got caught up heavily in the financial crisis thus debunking the myth that a common currency would bring greater prosperity for the entirety of the Eurozone.

Though Euro was finally brought out as coins and paper notes in 2002, the preparation for the same had started long back. This idea first started taking shape in the early 80s era when Europe was facing economic hostilities and severe imposition of trade barriers from the United states of America. The entire European turf faced stagnation and high levels of unemployment. The disappointing macroeconomic performance of many countries during the 1970s, which often featured the “stagflation” combination of high unemployment and high inflation, led to an increased focus on the need for central banks to cater to managing the public’s expectations about policy and on the benefits gained from central banks committing to a low-inflation policy and being given independence from political control. The projected growth rate was slumping, disintegrating European economies from each other since they had lesser and lesser incentive to engage with each other on the economic front. This also resulted in factionalism in Europe. This led to a surge of political fervor amongst policymakers and economists to project Europe as an ‘Integrated Europe’ because it held some symbolic and aspirational value for them and also made it easier for them to cash on people sentiments. These developments in Europe called for the conception of a common currency which would facilitate lower transaction cost, more stable exchange rate in the continent and easier comparison of prices between different countries resulting in greater overall transparency. At the same time, it would also cater to the dream of ‘the integrated Europe’. The 1992 Maastricht treaty was signed and the euro was released in virtual form in 1999 followed by currency notes in 2002. Initially a success, the 2008 recession exposed many flaws in the conception of the euro which was only superficially analyzed earlier.

The projected growth rate was slumping, disintegrating European economies from each other since they had lesser and lesser incentive to engage with each other on the economic front. This also resulted in factionalism in Europe. This led to a surge of political fervor amongst policymakers and economists to project Europe as an ‘Integrated Europe’ because it held some symbolic and aspirational value for them and also made it easier for them to cash on people sentiments. These developments in Europe called for the conception of a common currency which would facilitate lower transaction cost, more stable exchange rate in the continent and easier comparison of prices between different countries resulting in greater overall transparency. At the same time, it would also cater to the dream of ‘the integrated Europe’. The 1992 Maastricht treaty was signed and the euro was released in virtual form in 1999 followed by currency notes in 2002. Initially a success, the 2008 recession exposed many flaws in the conception of the euro which was only superficially analyzed earlier.

WHAT WENT WRONG WITH EURO?

Assumes that Europe has homogeneous economies
It didn’t take into account the disparity in competitiveness and capability that existed between Euro members. Countries in Southern Europe like Spain, Portugal and Greece were facing higher inflation rates, caused primarily by rising cost of labour. This made their exports costlier than the equivalent exports from stronger economies like Germany and the Netherlands. Earlier this would not be an issue because these weak economies would devalue their currencies frequently to competitiveness. For example, Italy had devalued its lira seven times between 1979-92. With the introduction of a common currency, this could no longer be possible. Also, due to lack of internal exchange rate in the euro, the Spanish and Portuguese goods became more and more costlier resulting in current account deficit in these countries.
One interest rate for the whole of Eurozone
Spain has been facing higher degree of inflation then Germany but both have the same interest rate which is set for the entirety of Eurozone. For Spain, this interest rate shall be too low that results in inflation and current account deficit. For Germany, it would be too high resulting in slow growth and current account surplus. This process consequently led to divergence and EU members experiencing growth at different speeds. This regional disparity of growth created a situation of disequilibrium.
Efforts to transition into ‘Optimal Currency Zone’ failed
A zone where the implementation of a common currency facilitates economic efficiency and smooth flow of inter and intra-zone transactions is known as ‘Optimal Currency Zone’. The most prominent example of the same is the United States of America where all the 50 member states use the same currency, dollar. There are primarily two broad reasons why the Eurozone couldn’t convert itself into an ‘optimal currency zone’- geographical immobility and Lack of fiscal union.
Geographic immobility
If the state of Alabama faces an unemployment crisis, they can easily travel to wealthier states like California and New York for better employment opportunities. The person is free from the hassles of obtaining visa, work permit and other legal formalities. This saves time and money and makes mobility easier. However, this is not the case with the Eurozone. It is not easy for an unemployed Spanish worker to move to Germany- they may not speak the language, making it difficult to secure a job and living accommodation locally.


Lack of fiscal union
Eurozone doesn’t have a fiscal union which means each has its own budget and budget deficit. This caused a lot of pressure on southern European countries to pursue austerity to reduce the deficit. A relatively poor state like New Mexico receives a net flow of over 250 percent of its GDP. Such relatively big transfers can’t happen EU wide due to lack of trust and political will. German voters might not be happy at the prospect of subsidizing a depressed Greek economy.
Eurobond crisis
In the Eurozone, Spain, Greece and Portugal no longer had a central bank that could print euros. People thought the euro would never face liquidity issues. The assumption was that the euro would boost investor confidence. However, it didn’t pan out this way. Investors noticed a rising budgetary deficit and more importantly, no guarantee of liquidity. They started selling bonds of Greece, Ireland and then Spain causing bond yield to rise quickly due to fear of default. When the government can’t sell bonds privately, they start adjusting the budgetary deficit. This is done by cutting on government spending, increasing taxes which leads to low rates of growth and a bleak future. Economists and thinkers identified an urgent need to implement some structural reforms in the eurozone for equitable growth throughout the region. The assumptions that hamper the efficiency of the euro should be checked which include setting one interest rate on bonds for the entire region and the assuming easy mobility of labour pan-euro. It is also suggested that the central financial authority for the eurozone which is the European Central Bank should provide more liquidity to countries unable to sell bonds than it now presently does and promise to act as the last resort. A tough job for this central entity is to combat the political intolerance in the Eurozone which quick-started with Brexit and aggravated due to the pandemic. There is huge scope for further research especially in structural and economic reforms.


AUTHOR


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Sakshi Rai, SSCBS

She is currently pursuing Bachelors in Management Studies from Shaheed Sukhdev College of Business Studies, University of Delhi. She heads the editing department for The CBS Post, official newsletter of SSCBS. She is also a columnist and has written several opinion pieces covering multiplicity of topics. She enjoys debating and has participated at various tournaments. A hardcore Tharoor fan, she likes to read books on Indian subcontinent and its culture with a special liking towards politics and international relations.