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Euro revision notes

The Euro is the single European countries adopted by 18 out of 28 EU countries. The UK has not joined.

The Euro involves:

  • Common currency
  • Common monetary policy – Eurozone interest rates set by the ECB in Brussels.
  • Some fiscal rules, e.g. The Fiscal Compact (2012) limiting the amount of government borrowing (a balanced budget of less than 3% of GDP)

The Euro is the second largest reserve currency in the world after the US Dollar.

Benefits of the Euro

  • Lower transaction costs for trade, tourism and consumers.
  • Greater price transparency (leading to more price competition and lower prices for consumers)
  • Eliminates exchange rate volatility, encouraging trade and inward investment.
  • In theory, lower inflation and lower interest rates.
  • See more: benefits of the Euro

Problems of the Euro

  • Common monetary policy not always suitable for all 18 members. e.g. southern Eurozone in recession, but ECB have kept monetary policy quite tight (relatively high interest rates). This means countries can be at risk of recession (if ECB keep interest rates too high) or boom if ECB don’t tackle inflationary pressure in that country.
  • Uncompetitiveness. Countries in the Euro cannot devalue their currency against European neighbours. If an economy becomes uncompetitive (e.g. relatively higher inflation / wages) then they will become uncompetitive and there will be: a fall in demand for exports and growth and a current account deficit.
  • Geographical immobilities. The Eurozone is quite diverse, it is difficult for unemployed Spanish workers to move to Germany to take advantage of jobs there. This lack of mobility makes a common monetary policy difficult.
  • Fiscal compact has created pressure for austerity, leading to lower growth. Countries in the Eurozone have few policies to increase aggregate demand (AD) in a recession.
  • Higher bond yields. Countries in Eurozone have faced rising bond yields because they have no Central Bank to act as lender of last resort.
  • Recession and low growth. Since 2008, the Eurozone has experienced low growth, high unemployment. Many fear the Eurozone has a deflationary bias.

More details – problems of the Euro

Should the UK join the Euro?

Yes

  1. Reduce exchange rate volatility
  2. Encourage trade and inward investment with main trading partners

No

  1. UK would suffer from losing independent monetary policy, e.g. no quantitative easing could have made recession worse.
  2. UK housing market very sensitive to interest rates.
  3. UK exports could end up becoming uncompetitive lack Southern Europe
  4. Growth likely to be lower.
  5. Past five years suggest membership of the Euro could contribute to very serious recession.

Should UK join the Euro?

Possible essay questions on the Euro

  • Discuss whether an Eastern Europe country like Latvia is likely to benefit from adopting the Euro?
  • Discuss how the UK economy would be affected if it adopted the Euro?

 

Topical reading

 

 

 

 

 

 

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Causes of Europe’s deflation problem

The European Union is facing the prospect of a serious bout of deflation (or at least, very low rates of inflation / disinflation) Deflation occurs when prices fall. But, very low rates of inflation are considered to raise problems associated with deflation.

In the Eurozone, the main index of inflation has fallen to 0.7% -  This is well below the ECB’s inflation target of 2%. Some regions and countries in the Euro, such as Greece are already experiencing deflation. In Greece prices fell 1.8% last year and the consumer price index reached the lowest level for 51 years (FT Link). Spain and Italy in particular, are nervous about the prospects of experiencing deflation in the future.

EU inflation

Inflation ECB – Inflation has since fallen to 0.7%

Causes of deflation in Europe

Eurozone-unemployment

1. Unemployment. Unemployment in Europe has increased significantly since 2008, with the unemployment rate now reaching 12.2%. High rates of unemployment put downward pressure on wages, as the unemployed are more likely to accept lower wages.

2. Internal devaluation. A striking feature of the Euro is that countries which became uncompetitive in the boom period, can not devalue their currency to regain competitiveness. Therefore, the only option is for them to pursue internal devaluation. This means reducing prices and costs in the economy – primarily cutting wages. By reducing costs, they can make their exports more competitive and regain competitiveness. But, with weak external demand, it is proving a difficult and slow process for southern Europe to restore competitiveness compared to northern Europe.

3. Weak demand. The fundamental cause of deflation is weak demand within the Eurozone. Firstly, several Eurozone economies are pursuing fiscal austerity to try and reduce budget deficits. These spending cuts and tax increases are causing a significant drop in demand. Because of the relatively tight monetary policy, and strong Euro, demand is not coming from other sectors of the economy.

4. Fear of inflation in Germany. With inflation falling to 0.7% and unemployment of 12%, you would expect economists to be unanimous in the desire to overcome the threat of deflation and promote growth in Europe. But, in Germany the prevailing economic orthodoxy is still to worry about inflationary pressures and a possible loss of ‘confidence’ – should the ECB promote monetary loosening. Recently The ECB cut interest rates by 25 basis points, after the fall in inflation rate from 1.1 to 0.7%, but several Germany economists dissented arguing that it is wrong to cut interest rates given the possibility of ‘inflationary’ pressures in Germany. In the past, Angela Merkel has argued that Germany would need an interest rate increase if the German economy was taken in isolation. (FT link) The underlying fear of inflation means there is tension within the ECB and a reluctance to loosen monetary policy to target deflation.

eu-inflation-krugman1-blog480

Source: Eurostat: via Krugman Continue Reading →

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EU success or crisis?

The German Finance Minister Wolgang Schauble has been a strong advocate of austerity, supply side reforms and ‘sound money’ policies. (i.e. sticking rigidly to inflation targets). Generally, this has been the preferred approach of Europe to the ongoing debt crisis and recession of the past few years. Recently, he has claimed that the European economy is recovering well and this is vindication that the broad approach of fiscal discipline and structural reforms are laying a foundation for strong economic growth in the future.

Writing in the Financial Times, Schauble states:

While the crisis continues to reverberate, the eurozone is clearly on the mend both structurally and cyclically.

What is happening turns out to be pretty much what the proponents of Europe’s cool-headed crisis management predicted. The fiscal and structural repair work is paying off, laying the foundations for sustainable growth. This has taken critical observers aback. It should not have, because, in truth, we have seen it all before, many times and in many places. Despite what the critics of the European crisis management would have us believe, we live in the real world, not in a parallel universe where well-established economic principles no longer apply. (FT – Ignore the doomsayers)

Others are much more critical arguing that this view ignores the long-term damage being done to the EU economy by years of deflationary policies. Also, his view ignores the damage of self-defeating austerity which has caused mass unemployment across Europe and rising debt to GDP ratios.

Economic recovery in Europe

EU growth

source: Eurostat

Firstly, the recovery is very timid. The Euro area did grow by 0.3% in the Q2 of 2013, but Eurozone real GDP is still -0.5% lower than 12 months ago. The important point is that since 2008, Europe has failed to reach a normal rate of economic growth – there has been no escape velocity. The recovery of 2010 petered out.

Reasons to hold back on the champagne and not celebrate the EU economy.

1. Quarterly growth figures are very limited in determining the success or otherwise of the economy. The European recession began in 2008. The fact you have one quarter of positive growth in 2013 Q2 doesn’t overcome the five years of recession. Real GDP growth has fallen drastically behind the trend rate of growth necessary to get anywhere close to full capacity.

2. Unemployment. Unemployment is arguably the most useful statistic for understanding the degree of spare capacity and wasted resources in an economy. High unemployment has very high social costs in terms of lower incomes, declining morale, and wider social problems. On this metric, the Eurozone faces an unprecedented crisis. Yet, it tends to be brushed aside by European policy makers.

Eurozone-unemployment

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Latvia to join the Euro

After enduring a deep economic crisis, Latvia are poised to be ‘rewarded’ with membership of the Euro in 2014.

latvia-eu

The Latvian miracle story

It seems a strange that countries are so keen to join the Euro, when membership of the Euro has been a major factor in creating a real depression amongst many Euro countries. Yet, the debate about Latvian joining seems to be from a parallel universe, where the ongoing crisis is neatly forgotten.

Prime Minister Valdis Dombrovskis said that the European Commission (EC) had given the go ahead for Latvia for adopt the euro from early 2014. “Joining the eurozone will foster Latvia’s economic growth for sure,” Mr Dombrovskis said. I’m sure that is what the Greek, Spanish and Portuguese political leaders said when they joined in 2000.

latvia-czech-republic

There is opposition – with many in Latvia concerned about ‘rising prices’ after joining the Euro. But, given the experience of the Eurozone in the past few years, rising prices are likely to be the least of Latvia’s concerns over the next few years.

From an outsiders perspective, it’s hard to understand the attraction of joining the Euro. I think the underlying motive must be a desire to join up with Europe and move away from Russia and the East. Given Latvia’s past, this is understandable. What is unfortunate is that being a good European citizen seems to involve joining an unworkable single currency and monetary policy.

Despite the European obsession with meeting fiscal deficits, there has been much less concern about whether the Eurozone is fundamentally an optimal currency area. An optimal currency area is a geographical area where the benefits of one currency are greater than the downsides. An optimal currency area will need:

  • Strong labour and capital mobility
  • Lack of geographical barriers
  • Fiscal transfers from strong regions to weak ones
  • Similar labour costs and similar inflation rates.
  • The ability to cope with a single monetary policy (interest rate)
  • The ability to retain competitiveness within the fixed exchange rate.

Continue Reading →

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If the UK had been in the Euro – how would it affect the economy?

Readers Question: my question is If the UK. had joined the Euro back when it first started would the UK. have benefited like Germany or would we be in the same situation as Greece, Italy, and Spain?

If the UK had joined the Euro from the start in 1999, the UK economy would definitely have been affected in a variety of ways. Firstly, in the Euro we would have a fixed exchange rate, no independent monetary policy, fiscal policy would be severely curtailed, and the UK bond market would have had no intervention from the Central Bank.

In short, we could have expected – a bigger housing boom and bust. A deeper recession in 2009. Rising bond yields in 2010-12, leading to greater austerity. No devaluation and less competitive exports.

Housing Bubble

ECB Interest Rates

The years 2000 to 2007 were relatively stable for the Eurozone and Euro. However, due to stronger growth in the UK, ECB interest rates were lower than the Bank of England interest rates. Between 2003 and early 2005, ECB interest rates were 2%, UK rates were higher at around 4%.

UK base interest rates

If the UK had been in the Euro, we could have seen a bigger asset bubble during the years 2003-06. Lower interest rates would have encouraged more people to enter the housing market, causing an even bigger increase in house prices. These lower interest rates would have caused higher economic growth in the period 2000-07, but at the cost of a bigger credit and housing boom. The UK is particularly sensitive to interest rates because so many homeowners have a variable mortgage.

If house prices had risen faster (04-07), they would have been a bigger fall, post 2008. The fall in house prices post 2008 was a drag on consumer spending and contributed to bank losses. If house prices fell at a great rate, then the financial crash would have been more painful and banks lost even more money.

Response to recession of 2008

The economic and financial crisis of 2008 hit the UK more than most other European economies. This was partly because the UK’s economy has a bigger reliance on banking and finance – sectors adversely affected by the credit crunch. Other European economies, such as Germany also saw a big fall in GDP during 2009, but were able to bounce back from recession quicker than the UK and southern Europe.

eu econ growth

In response to this fall in output, the UK pursued a different monetary and fiscal policy to the rest of Europe. If the UK had been in the Euro, we would not have been able to pursue this independent monetary and fiscal policy.

Continue Reading →

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Is a strong currency a good thing?

Readers Comment from post: Should the UK join the Eurozone

So now it is 2013. Britain has spent a number of years with it’s interest rate set at just about zero, has entered a triple recession, has lost it’s AAA credit rating and Sterling is only worth €1.15 a drop of over 30% against the Euro.

So for those who still cannot see the wood for the trees and still believe the “anti-euro” propaganda wake up and smell the coffee.

I will put it this way, despite the turmoil the Eurozone has been suffering for the last 5 years, despite it’s inability to drop interest rates to zero to make itself more competitive, despite it’s differing economies and demographics it has risen in value against the UK as a Nation but over 30%. Can you smell the coffee yet?

pound-euro

A while back, I wrote a post – How to measure success in the Eurozone? The main argument of that post is that you can’t measure economic success just from bond yields. In late 2012, the ECB were very happy to see falling bond yields – there was almost a sense that falling bond yields meant the Euro was now doing well, but falling bond yields alone don’t solve unemployment and the wider Eurozone crisis. Sometimes, we judge economic success from only a very limited standpoint, ignoring much more important factors.

One example, is judging the desirability of an economic policy from the strength of a currency.

When you have a large current account deficit, when your economy is in recession, a depreciation is exactly what the economy needs. Having a strong currency, when economic fundamentals don’t support that level just creates further economic misery.

One obvious example that springs to mind is the effort in 1992 to keep the Pound artificially overvalued within the ERM. To keep the Pound at a set level against the D-Mark, we put up interest rates to 15% and caused a severe recession. The strong pound was completely unsuitable for the UK economy, but we persisted with the policy because of a mistaken belief that keeping a ‘strong’ pound was ‘good’.

Another classic mistake was the decision in 1925 to rejoin the gold standard at a level that was unsuitable for the post-war UK economy. The consequence of this decision was deflation, low growth and a rising debt to GDP ratio. (see: UK economy in 1920s)In this case, the strong pound was damaging to the UK economy.

Strength of the Euro

The strength of the Euro has not necessarily increased living standards for people in the Eurozone. For those on the southern periphery of the Eurozone, the strength of the Eurozone has been an important factor in contributing to a prolonged recession and high unemployment.

eu-current-account-deficits

In 2008-11, Eurozone economies faced exceptionally large current account deficits of close to 10% of GDP (and upto 15% in case of Greece). This reflected a fundamental misalignment of the economy. Within the Euro, Portugal, Spain, Greece were uncompetitive, the Euro was too strong making their exports very uncompetitive. In the Eurozone, exporters couldn’t compete leading to lower demand, lower exports, and higher unemployment.

If the UK had been in the Eurozone, we wouldn’t have been able to devalue by 30%. The Pound could now be 30% overvalued. The consequence of this would have been:

  • An even larger current account deficit.
  • Lower domestic demand. The strong Euro would have increased demand for imports, and reduced demand for UK exports.
  • The recession would have been deeper, putting pressure on the government deficit.

Continue Reading →

Should the UK stay in the European Union?

In the past few years, there have been a noticeable increase in the calls for the UK to consider leaving the European Union. A few years ago, we may have enjoyed complaining about EU directives on the bendy banana (which didn’t really exist) but it was taken as almost sacrosanct that membership of the EU was in the UK’s interest.

What has changed and would we really benefit from leaving – and negotiating a free trade agreement, which enables the benefits of EU membership without the supposed costs?

Should We stay in the EU?

The Ideal of European unity.

The relative peace and prosperity in Europe since 1945, is a huge achievement, given the past century of inter-European conflict. Britain is an intrinsic part of Europe, whether it likes it or not. We should take the opportunity to be a member of the European Union and help maintain this European integration and harmony. If the UK left the EU, we would be increasingly politically isolated.

  • However, do we need to be a member of the European Union to achieve this? The UK could still contribute to European ideals without signing up for all the political and economic integration that the EU elite wish to pursue. European countries, who have stayed out of the EU, such as Switzerland and Norway maintain friendly relations with Europe.

Free Trade

One of the strongest benefits of the European union is the fact that it is our main trading partner, and membership of the EU has helped reduce trade barriers – both tariff and non-tariff barriers. European trade is critical to the UK economy. Leaving the EU, could put this important aspect of our economy under threat.

  • The hope of Eurosceptics is that we could leave the political integration of the EU, but maintain all the free trade agreements. Again the model is that Switzerland and Norway have not been disadvantaged by staying out of the European Union. Evidence suggests, the EU would be keen to accommodate the UK as a free trade partner.

“If the British cannot support the trend towards more integration in Europe, we can nevertheless remain friends, but on a different basis. I could imagine a free trade agreement.”

Continue Reading →

Predictions for the Euro 2009

Readers Question: Buying a new property in Montengro

  • 215,000 Euros’s
    paid 30% at exchange 1.47 to pound August 2007
    20% due in 2-3 months. 43 ,000 euros
    today exchange is bad news approx 1.23 to pound
  • further 30% due around Nov -Dec 2008
    20% on completion around April 2009

1.What are your predictions for the pound euro exchange rate at the time points above. June 08 – April 09?

I would be reluctant to stipulate a figure for the Euro / Pound exchange rate, especially with so much resting on your decision. People do talk of an exchange rate of 1 Euro to £1. This is because:

  • Weakness in UK housing market and UK economy. This could lead to lower interest rates in the UK in the next 12 months. If the UK housing market really collapses as some people fear, the £ will only get weaker.
  • Chance of Euro becoming worlds’ reserve currency instead of dollar. If central banks made the switch to the Euro, it would continue to gain in strength for a long time.

However, it is worth bearing in mind. Continue Reading →

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