omran & nayef costs and benefits of euro zone membership

What are the costs and benefits of membership of the Eurozone?:

What are the costs and benefits of membership of the Eurozone? Dedicated to Ms.Peters

Slide 2:

The Euro was introduced in 2002 and replaced the currencies of twelve national countries. These twelve countries became the currency union known as the eurozone. Four further countries have replaced their currencies with the euro and becoming part of the eurozone. The article discusses why the countries would wants to have the same currency and what problems this may have created for them.

Slide 3:

The costs of membership of the Eurozone Many articles in the UK highlighted the transition costs of moving towards the euro:  total costs would be in excess of €100billion by having to change systems to be able to cope with the new currency.  concerns over whether enough currency would be in place.  whether citizens would fully understand the new currency. 8 years on the concerns have withdrawn and the conversions cost were small as a percentage relative to the total GDP of the twelve initial members. A far greater concern is the costs that are presented in terms of individual countries being unable to set their own interest rates. Each eurozone country has a member that represents them in the European Central Bank meetings. Here they discuss the base interest rate for the eurozone for that month. This has lead to the problem where some countries may wish to have a higher central bank interest rate than other countries.

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A good example is Spain. During the first few years Spain experienced a boom based upon property. This situation required a much tighter monetary policy than that set by the ECB. According to The Economist the eurozone inflation rate has risen at an average rate of only 2.1% per annum. Country is now experiencing a housing bust that has resulted in the collapse of its construction industry and unemployment rising to 20%. Spain now has higher costs than its eurozone competitors making it harder for exporters to compete and worsening its balance of payments on its current account.

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As Spain cannot lower its exchange rate against other eurozone countries it cannot regain its lost competitiveness. This would have helped by lowering it’s the price of its exports and increasing the price of its imports making domestic goods more price competitive relative to other eurozone countries. Before it switched to the euro Spain had the peseta. With this they could have engineered a fall in the value of its own currency, lowering its base interest rate to one lower then its competitors. However, as it is a member of the eurozone now it cannot do this and must rely on the ECB to set an appropriate base rate. In an attempt to resolve this downturn the Spanish government could use an expansionary fiscal policy to pump prime the economy. However, in 2002 the eurozone countries agreed to a set of fiscal policy rules which disallowed countries from using excessive government spending to bail their economies out.

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Both Germany and France broke the rules in 2003 leading to suspension and then amendment of the Stability and Growth Pact. Countries eventually agreed to a get-out clause for members who experienced exceptional difficulties. Having experienced difficulties Spain decided to stimulate their economy with a huge fiscal stimulus. Now that countries have been freed to a greater extent there has been a growing unease amongst economists about the lack of fiscal centre. A big worry for countries and the ECB was that a eurozone country might run into funding difficulties as there is no system to bail a defaulting country out.

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The Benefits of membership of the eurozone. 1992, single market was created within the European Union. Designed so that European citizens could purchase goods and services from anywhere within the area. Single currency was an extension this idea, where the citizens were able to purchase free from government measures. This single currency was a further reduction in the barriers of trade between member states  enhancing freedom of choice and promoting competition. Key benefit of having same currency is increased trade. The Euro wipes out the exchange rate fluctuation and also lowers costs to firms. This was the reason Slovenia joined the eurozone. It has a small but open economy and with Germany as its trading partner it would benefit greatly from using the same currency. Trade increases were evident with an increase in output of 7.6%. A common currency allows businesses and consumers to compare prices much easier.

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Prices improve the economic efficiency as it acts as a mechanism to allocate resources in an optimal manner. The euro should also eliminate the problem of price discrimination. Another key benefit is that businesses in the eurozone no longer need to change their domestic currency into foreign exchange if they wish to purchase goods from overseas. Another complication for firms that trade in different currencies is that they may encounter exchange rate risks ( the risk that a domestic firm might have a contract with a foreign firm where is has to pay a fixed sum for the purchase of goods some time into the future.

Conclusions:

Conclusions - Economists still see the Euro as a doomed project. - The global economic downturn has put the decisions of the ECB sharply into focus especially for countries who experienced rapid and sustained falls in GDP such Spain & Ireland. - The one size fits all nature of the monetary policy meant that when the recession began, they could not make the decision to reduce interest rates. - Rates at the ECB came down from 4.25% to 1% with 7 reductions from October 2008 to June 2009. The speed and sharpness of the downturn was common for all eurozone countries. Rates were not see as out of place, as they were essential to avoid an even sharper recession.

Slide 10:

- Potentially, the recovery may be more problematic for the ECB. Some countries will recover more quickly leading to higher interest rates than others to control inflation. The ECB has found that the one size fits all policy fits no single country. - Another criticism of the eurozone is its current lack of common fiscal policy amongst its members. - The European Commision has no authority to compel member states to abide by any fiscal stimulus package. The lack of common fiscal discipline may yet come back to haunt the eurozone, as most eurozone countries have not kept their budget deficit under 3% of their GDP. For the countries that are now considering moving towards membership of the eurozones, they must weight up the costs and benefits very carefully.

Slide 11:

- For the 8 that are planning membership in the near future, the have been clearly decided that the positives, such as potentially making future gains from trade from greater price transparency and reduced exchange rate costs, outweigh the negatives such as losing the ability to set their own interest rates. short video to watch further explaining the previous slides  enjoy! http://www.youtube.com/watch?v=nGyJZVgMDfo