The Problem with the Euro

The Euro is a bold experiment to create the largest curreny area in the World. The Eurozone is a diverse area and whether it is an optimal currency area is a matter of debate.

The Euro involves:
  1. A single currency within the Eurozone area.
  2. A Common Monetary Policy. Interest Rates are set by the ECB for the whole Eurozone area.
  3. Growth and stability Pact. Limits on government borrowing, national debt and fiscal policy. However, in practice member countries have often violated the strict limits on government borrowing.

Problems of the Euro.

  • A common monetary policy involves a common interest rate for the whole eurozone area. However, the interest rate set by the ECB may be inappropriate for regions which are growing much faster or much slower than the Eurozone average. For example, if the French economy was in a recession, it would benefit from lower interest rates to boost demand. However, France no longer has the flexibility to be able to cut rates. Therefore, it could be stuck in a recession and not able to cut rates.
  • Not an Optimal Currency Area. If a state in the US like New York was in recession, it is argued that people in New York could move to New England and get a job. However, in the Eurozone this is much more difficult; it involves moving country and possibly learning a new language. There are more barriers to the movement of labour and capital within a diverse region like Europe.
  • Limits Fiscal Policy. With a common monetary policy it is important to have similar levels of national debt, otherwise countries may struggle to attract enough buyers of national debt. This is a growing problem for many Mediterranean countries like Italy, Greece and Spain who have large national debts. For example Italy's national debt is over 100% of GDP.
  • Insulation against Currency Crisis. It is argued that being a member of the Euro protects a country from a currency crisis. Therefore, there is less incentive for countries to implement structural reform and fiscal responsibility. This is even more important given the fact that devaluation is not an option.
  • No Scope for Devaluation. Euro countries are locked into the fortunes of the Euro. The Euro has been appreciating sharply in recent months because it has become an alternative to the dollar. If the Euro became the World's reserve currency its value could appreciate even more. However, the strength of the Euro is creating problems for European exporters and the European tourist industry. The appreciation in the Euro could start to harm prospects for economic growth in the Euro Zone. The main problem is that there is no flexibility for depreciating. This is also a problem for countries with large current account deficit. Traditionally, devaluation is a solution to current account deficit because it makes exports cheaper, but European countries have lost this as a possibility.

Problems for UK Economy.

UK economy has additional problems which make joining the Euro a bad idea.
  • Housing market. Many in the UK have a mortgage which is a big % of their disposable income. This is related to the high cost of buying houses in the UK.
  • Variable Mortgages In the UK more homeowners have variable mortgages. These two factors means UK consumers are very sensitive to changes in the base rate. If the ECB kept interest rates higher than the UK needed it would create serious problems in the UK. Arguably to join the UK would need to reform its housing market and reliance on variable mortgages.
Related Posts on the Euro
Perma Link | By: T Pettinger | Thursday, April 24, 2008
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