Costs and benefits of the EMU

Costs and benefits of the EMU Abstract: This paper contributes to the ongoing debate over European Monetary Union (EMU) including the costs and benefits of joining it. Advocators of EMU stressed that it is essential to create a stronger European Union with greater economic, political and social cohesion, whereas the opponents did not support this stage of the European Unions construction such as the United-Kingdom, Denmark and Sweden, reviewing the merits of a single currency (OCA) and the requirements for a stable currency (Convergence Criteria). (Bernhard Winkler, 1996) Identify and discuss the costs and benefits of joining the Economic and Monetary Union (EMU)? Do the benefits outweigh the costs? Introduction According to Franà §ois Mitterrand, â€Å"EMU is seen as a mean to recover some influence over European monetary affairs.† (Franà §ois Mitterrand, 1992)The French left wings president at time wanted the emergence of the European Union against the US dollar which has been widely used as the yardstick measurement for all currencies. In Europe, the existence of different national currencies was considered as the remaining barriers for a barrier-free single market and the influence of the dollar pressed the European Union (EU) to form an Economic and Monetary Union (EMU). The genesis of the EMU with the initial impulse given by the Werner Report in 1970, then failed in 1973 with the oil crisis and finally relaunched with the Delors Plan in 1989 and the Treaty of Maastricht in 1992, was noteffortlessly. The EMU is a type of trade block involving a single market and a common currency. At the European scale, it involves a single European market within its borders and the adoption of the Euro. Economists usually refer to the EMU as an economic trade off between perceived benefits and cost of joining the area (Thomas D. Willett, 2002). There are diverging views on the extent of these costs and benefits, and therefore, especially on the question whether to join the EMU or not. The aim of this paper is to analyse the key issues surrounding the entry in the EMU, and balance positive and negative aspects. The pros and cons regarding the EMU require a careful analysis of the economic benefits and drawbacks at both national and company level. Debate surrounding the EMU There are many benefits that a country will have by entering EMU. Recently, the euro has gained a lot of influence since many European nations have adopted it. Indeed, the benefits of EMU increase and costs decrease as the level of integration intensifies. (Krugman, 1990)The growing importance of the euro in international trades and the increasing trade activities which result from adopting the currency clearly shows that benefits will outweigh costs. For a country international trades are fundamental in order to have a stronger economy. Therefore, the â€Å"antis-EMU† advocate that the process will submerge the individuality of the European nations in an â€Å"unwieldy federation, hobbled by bureaucracy, commanding little popular support and imposing a crippling burden of regulatory and other costs on Europes economies† (David Currie, 1997, pp.14) They believe that an organized Europe will have a negative impact for most member states as it will also â€Å"reduce the volume of trade and would certainly increase the level of unemployment† (Martin Feldstein, February 20, 2008). In order to join the EMU, a country must correspond to the Maastricht Convergence Criteria: price stability, sustainable public finances, exchange rate stability and durable convergence. The term â€Å"convergence† refers to the process of unifying technological and non-rival domains, preparing late countries in terms of structure and institutions to match with those at the forefront. One of the first obvious benefits is that the implementation of those criteria represents a factor of macroeconomic stabilisation and sustainable economic growth for both EMU countries and future members. However, the convergence requirements are also a clear example of conflict because they are considered as lacking economic rationale and imposing unnecessary pain. Many economists have attacked the convergence criteria, responsible of provoking instability and serving no other purpose except to delay. (De Grauwe, 1993) The convergence criteria and EMU itself seek to guard against â€Å"unsustai nable budgetary policies in a member state† because these are seen to lead to either â€Å"default or debt monetisation† which would â€Å"be a major threat to the overall monetary stability† (European Economy, 1990:100) Furthermore, the convergence criteria make clear that fiscal discipline is defined as the avoidance of an unsustainable build-up of public debt (Emerson, 1992, pp.107) and the transition to EMU for a country will amplify the domestic effectiveness of national fiscal policy for stabilisation purposes. (Emerson, 1992, pp.115) Benefits and costs of joining the EMU Our aim is to understand the incentives of the players in the EMU, and a natural starting point is to assess economic costs and benefits of a single currency for a country like France as an example. More or less, there are microeconomic benefits versus macroeconomic costs. a) Transaction costs and stable environment One of the most obvious benefits is the resulting ease of transactions across the European Union. Countries are using one currency and as a matter of fact, the elimination of exchange rate fluctuation helped to eliminate transaction costs in intra-EU trade. Firms and business are both saving time and money. For example, an estimated $30 billion[1] a year is spent on foreign exchange transactions. The transactions involve the change from one currency to another but also from accounting systems. Additionally, joining the EMU eliminates the possibility of exchange-rate variation with the EMU zone. If exchange rates move irregularly and unsystematically in response to arbitrary speculation, exchange volatility imposes a macroeconomic cost (David Currie, 1997). Thus, its elimination represents a real advantage as it provides a more stable environment for trade within the euro zone by lowering risks and uncertainties as the economy is more flexible and resources more mobile. b) Monetary policy and the European Central Bank Despite affecting a fundamental aspect of a countrys sovereignty, member-states must abandon monetary policy. Additionally, members are deprived from revenue of seigniorage which is the net revenue derived from the issuing of currency. This loss mainly affects high-inflation rate countries such as Greece or Spain for example. Monetary policy is not anymore at the national level but depends on a supranational authority, the European Central Bank, headquartered in Frankfurt, Germany. Established in 1998, the ECB is responsible for monetary policy covering the sixteen member States of the Euro zone. Granting monetary control to the ECB means that National governments are giving monetary policy instrument such as regulating exchange rate and interest rate, and this is likely to involve a cost. This cost will occur during recession or inflationary boom, when a country will be unable to raise or lower interest rates independently of other countries within the EMU. c) Fiscal power of member-states Joining EMU severely limits the fiscal power of member-states. While they maintain formal responsibility for fiscal policy, member-states will have to show fiscal rectitude to avoid penalty. Convergence criteria require countries to reduce their debt which produced a ‘squeeze effect (Gà ¤rtner, 1997) for countries with loose fiscal policy. Indeed, fiscal policy remains the only macro-economic tool that is available to governments. At the same time, the union has the power of coordination and surveillance, and the ability to recommend modifications of fiscal policy and to apply sanctions against governments that have no taken the recommended steps. d) A single currency and its effect on public support As we already mentioned earlier, a member-state joining the EMU will have to adopt a common currency: the euro. Despite the fact that the adoption of the euro will clearly affect the countrys sovereignty, some people ‘feel closer to other countries (European Commission, 2002) which can bring Europeans together and build a notion of European identity. Therefore, the adoption of a common currency can result in undermining a nations identity. Currencies such as the â€Å"Francs† or the â€Å"Deutsch Mark† have symbolized economic prosperity, especially due to the fact that people trusted them. Moreover, the â€Å"Franc† was the French national currency since 1795 and has remained for two hundred and four years. The Deutsch Mark had the reputation as one of the worlds most stable currencies. For a country like France or Germany, the change of their currencies was a memorable step. Moreover, an obvious economic consequence is the impact on the purchasing power. For example, in France the switch from â€Å"Francs† to the â€Å"Euros† had a major effect on the French purchasing power. Twenty euro is the equivalent of approximately a 120Francs and this was perceived as a large amount of money in terms of purchasing power before the introduction of the new currency. While the adoption of the euro was meant to bring stability over the long-term, a study has been conducted showing that price rises were evident in the service sector such as restaurants, cafà ©s, hairdressers and recreational and sporting services. (Eurostat, 2003) Nevertheless, French consumers have noticed a change in the cost of living. Additionally, adopting a new currency is not always the easiest thing to do. e) Effects on firms and businesses Another benefit is the increase in attractive opportunities for foreign investors and these effects are unevenly spread across firms and businesses. Thus, larger firms will benefit more from EMU. For example, strong domestic enterprises will benefit from a greater degree of internationalisation of their markets. It will be especially helpful to small and medium sized enterprises which may not be able to reap sizeable economies of scale. Nevertheless, firms and businesses will be the first to experience the negative effects from joining the EMU. For example, travel agents and banks that are losing commission on currency exchanges and European currency traders will no longer be able to exert this business. Moreover, the single currency may lead to the â€Å"Europeanising† (Brown, B.2004, pp. 57-60.) of labour markets within the EMU zone. Consequently, it would be much easier to compare wages across the zone, especially in sectors where trade unions wield bargaining power. This w ill lead to an increase of wages and could engender major problem to companies outsourcing in low wages countries such as in Eastern Europe. The single currency will remove just the elements of labour-market flexibility. f) Price transparency and price convergence Nevertheless, joining the EMU will foster competition as there is greater price transparency across countries. Indeed, a single currency makes easier to show how prices differ between countries. It has been found that â€Å"the prices of goods differ considerably in different countries and continents due to the differences in currency.† (McCallum, 1995, pp24-25) As an example, before EMU, a customer living in France was able to buy a high value-added car cheaper when going in Germany. Hence, this leads to lower prices in the short to medium run because consumers can buy from the cheapest source and thus, drive prices down as companies are running under pressure. Indeed, â€Å"The formation of the euro zone and the SM of almost 300 million consumers will inevitably sharpen competitive pressures throughout Europe†. (Spanos et Al., Greek, pp.638) The subsequent enhancement of competition will increase economic efficiency and should cause price convergence. (Spanos et Al., Greek, pp.639) Consequently, the EMU provides information to its members and thus, enables them to make wiser decisions. g) â€Å"One fit all† policy problem: Moreover, other problems of joining the European Economic and Monetary Union will occur in the medium to long term. Indeed, the concern is that whether the states are sufficiently similar for them to co-exist with a common currency. For example, not all states are at the same stage of the trade cycle which represents a periodic fluctuation in the rate of economic activity as measured by levels of prices, production and employment. As an example, the UK is the worlds fourth largest economy and the second largest in the EU. The City of London represents Europes major European financial centre. The case of the UK has specific arguments: the UK has a lower level of intra-EU trade, one of the highest percentages of home owners and is affected differently by oil price movements due to different arrangements. It is then weaker and more vulnerable to external shocks which are unexpected shocks that do not affect every nation equally. (D. Johnson, C. Turner, 2nd edition, p180-183) Hence, if t he UK joins the euro, they will have to increase their exchange risks because the euro is turning around the dollar. The pound for example is neutral compared to the dollar and the euro. Consequently, the inappropriateness of one monetary policy for so many states is a major cost of joining the EMU. The case against the UKs entry in EMU depends also on other factors such as the recession the country is undergoing and the influence of the United-States. Benefits outweigh the costs? The case of Greece is a good example to show how benefits can outweigh the costs. Indeed, Greece has recently entered the EMU and thus, represents a good example for a number of candidates. Hence, it is an example of an economy in transition that has made a lot of progress in order to fulfil the macroeconomic convergence. A study of Greek firms has been conducted by Spanos (Business strategy analyst at Athens University) which helps to understand how firms react when entering the EMU and found that leading Greek firms â€Å"appear fully aware of the dramatic changes they will have to address in the near futureIn line with recent empirical evidence, the findings presented here are encouraging in that they suggest a strong learning effect that has presumably led Greek management towards convergence.† (Spanos et Al, pp.646) We understand that both EU membership and the panorama of competing in the EMU have acted as major catalysts. In short, the EMU has contributed toward the dev elopment of western-type of management style. Additionally, Greek firms have new challenges to overcome and this requires new competitive strategies, organizational structures, and management processes. Consequently, Greek firms strategy has shifted toward offer better quality products and services, and a tighter cost control. Trade theories are examples of why benefits outweigh costs. (Aiginger, K. et al, 1999, pp.3) The traditional theory was described by Ricardo in 1817; a country can achieve a â€Å"comparative advantage† resulting from differences in productivity or endowments between countries and regions. Consequently, trade liberalization and economic integration will result in production re-location and increasing specialization according to comparative advantages. Additionally, Mundell (1961) McKinnon (1963) and Kenen (1969) identified the reasons why a country should or should not enter a monetary union. If for every member-state benefits outweigh costs then the currency area is optimal. An â€Å"optimum currency area† (OCA) considers the premise that â€Å"when an external shock hits the economy, it is easier to adjust the exchange rate rather than domestic prices or wages.† (A. Belke and D. Gros, (1997). pp. 3/50) Indeed, this approach assesses what a country loses by giving up the exchange rate as an adjustment instrument. Conclusions To conclude, according to Martin Feldstein, EMU is seen by France as an opportunity to be a â€Å"co-manager† of Europe as an equal of Germany. Furthermore, it has been assumed that economic integration among the European countries will lead to convergence while reducing asymmetric shocks. However, classical theories assess that integration results in more specialization due to comparative advantage. Hence, core economies (France and Germany) may benefit at the expense of less efficient economies such as Eastern member-states. Furthermore, with a Single Market, firms will have to expand in size in order to compete. Such large firms are mostly located in core economies of the EU. However, Greece case study showed that EMU has contributed to the development of firms by offering higher quality products and services. 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