For Better or Worse, The Euro is Here to Stay [2/2]

Costs and Benefits Compared

Eichengreen does not discuss the costs and benefits to European countries for maintaining (or adopting) the euro. In order to get a better picture as to why the euro may survive over the long run, we must first understand the costs and benefits associated with it.  In this paper, we identified one of the foremost benefits as reducing price uncertainty because a common currency improves the allocative efficiency of the price mechanism. Several other key benefits include reducing transaction costs between European countries, major welfare improvements resulting from eliminating extreme movements in the exchange rates, and greater price transparency provided by a common currency. By far, the most significant costs associated with the euro are that a country relinquishes monetary policy when joining the currency union. If they tried to implement monetary policy when under a currency union, then capital would flow out of the country, its currency would depreciate, and output would drastically fall. Therefore, when confronted with a loss of domestic competitiveness, that country cannot simply reduce wages and prices to try to regain competitiveness. In figure 1 illustrated below, De Grauwe helps us draw some important conclusions concerning the importance of costs and benefits associate with a common currency (De Grauwe, 2010).

            The intersection point of the benefit and the cost lines “determines the critical level of openness that makes it worthwhile for a country to join a monetary union with its trading partners” (De Grauwe, 2009). To the left of that intersection, the country is better off keeping its national currency, and to the right it is better off when it relinquishes its national currency, replacing it with that of its trading partners’. In figure 1(a) the extreme view of the ‘monetarists’ is shown, claiming that national monetary policies are ineffective as instruments to correct for asymmetric shocks, regardless of such shocks being temporary or permanent; even if they are effective, the use of such instruments invariably makes countries worse off over the long run. Since the critical intersection point that makes it worthwhile to form a union is close to the origin in this graph, many countries in the world would gain by relinquishing their national currencies to join a monetary union. On the other hand, figure 1(b) presents the ‘Keynesian’ view that the world is full of rigidities, i.e. wages and prices are rigid and labor is immobile, therefore leading one to conclude that national monetary policies and the exchange rate are powerful instruments in absorbing asymmetric shocks (De Grauwe, 2009). Such a view is also represented by the original Mundell model: the cost curve is far away from the origin, implying that relatively few countries should find it in their interest to join a monetary union. Lastly, such a view also implies that many large countries that now have one currency would be better off splitting the country into different monetary zones (De Grauwe, 2009).

Why Euro Crisis Isn’t Over: “The Rotten Heart of Europe” or Hope for the Future

The question that still remains to be answered in this paper is: are the reasons that Eichengreen outlines in his article (and the view presented by monetarists in figure 1a) strong enough to silence the vocal naysayers of the euro’s survival such as the Keynesians and Bernard Connolly in The Rotten Heart of Europe? On one hand, there can be no doubt that the euro has the potential of becoming a major international currency. It has already done so in the international bond market and by acting as an international reserve currency. But is the situation in Europe getting worse and worse from the perspective "of real live people, and families and firms and economies," as Bernard Connolly still holds (Carny, 2013).  For example, “in early 2013 the EU reported that the euro-zone economy shrank by 0.9% in the fourth quarter of 2012. For the full year, gross domestic product fell 0.5% in the euro zone” (Carny, 2013).  Connolly predicts that, in the foreseeable future, probably the same members of the currency will be in place, though the monetary union will emerge more closer to something like a banking union or disguised transfer union; in a doomsday scenario, Connolly also predicts that there will be further threats of cycles of deflation, depression, and default in southern Europe, the Iberian peninsula, and potentially other regions in Europe. Whether or not Connolly is right is a controversial matter of debate.

However, in both Connolly’s and Eichengreen’s assessment, the Euro is probably here to stay, for better or worse. What is contended, then, is whether the euro will act as a source of stability in the European market and whether it will establish a firm position as a world currency. In order to achieve these two objectives, it is imperative that the economic size of the Eurozone increases, that there be macro and monetary stability, and that there is depth and sophistication of the financial markets backing the currency. Beyond that, the precise policies on which European governments cooperate will tell the tale of the euro’s future.

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