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The economic logic: why countries entered the Eurozone

Evert-jan Quak | 18 December 2015

The idea that the euro would bring more stability, trade and employment to Europe was economically overemphasized for political and commercial reasons.

Background article

This is a background article for our longread Ideals versus reality - A false start for the Eurozone.

Click here to go to the full longread

In the 1990s the debate about the pros and cons of the establishment of the Economic and Monetary Union (EMU) was biased: it was thought that a single market needed a single currency based on several economic assumptions. First, European institutions, many national institutions and political parties believed that handing over the conduct of monetary policy to an independent European Central Bank (ECB) would improve the credibility of anti-inflationary policies. They thought that strict budgetary rules and a focus on low inflation would result in stable prices and wages, which would make the Eurozone more attractive for international investors and the euro a credible international currency. This argument looks sound, but already in the 1990s several economists, like Martin Feldstein, noted that European countries had been rather successful in reducing inflation during the 1990s without an independent ECB.

The second economic argument raised by the European Commission many times in the 1990s was that a single currency would reduce transaction costs and uncertainty, thereby promoting efficiency and trade within the single market. Again, this might look a sound argument – it makes sense that removing exchange rate barriers for intraregional trade within a single market would result in cost reductions, lower prices, and market efficiency. However, independent studies back in the 1990s indicated that transaction costs were insignificantand had a low impact on trade and prices. Furthermore, exchange-rate variability and uncertainty have only small effects on trade and investment. See for example, Barry Eichengreen and Jeffrey Frieden’s publication (1993) and Jeffrey Frieden’s article (1998) about the winners and losers in the single currency.

Another economic assumption voiced in favour of the single currency in the 1990s was that it was necessary to reduce the risks associated with asymmetric shocks within the European Union. The European Monetary System (EMS) that preceded the EMU allowed European currencies to fluctuate within strict bands. But the system was not sufficient to protect against the impact of speculators and it did not convert member states’ economic, social and fiscal policies so that they could avoid speculation. The idea was that removing different currencies and different exchange rates within the European Union would reduce speculation and stabilize national economies and avoid crises, as a single currency could only create common shocks. This assumes an optimal currency area, which means that countries within the monetary union are economically identical and have fully free labour mobility. But, according to the available evidence, the EMU member states are not an optimal currency area. Language and cultural barriers make free mobility of Europeans less efficient. And the economies within the Eurozone are not economically identical, which means that they do not react the same to shocks and recessions. And in the absence of a well-functioning political union and any substantial mechanism for interregional transfers of fiscal funds the single currency was always likely to contribute to economic instability and regional disparities. There were many economists who had already mention this back in the 1990s; see, for example, Tamim Bayoumi, Rudiger Dornbusch, and Jeffrey Sachs.

It is interesting to quote Harvard University economist Jeffrey Frieden, who predicted the problems the Eurozone now faces due to regional disparities in his publication in Foreign Affairs as far back as 1998.

“One of Europe’s notoriously weak financial systems, say that of Spain, is threatened by a wave of bank failures. The national authorities are unable or unwilling to foot the enormous bill needed to stave off bank runs and incipient panic. They turn to the ECB, demanding a loosening of monetary policy to help their banks. Perhaps they even insist that the ECB and its member central banks provide short-term loans to the troubled Spanish banking system. The ECB could bail out its bankrupt member. This course would be unpopular in countries unaffected by the crisis, for the bailout might mean raising inflation elsewhere and sending other people’s money to Spain. And the bailout might itself encourage a run on other weak banks, now that the ECB has set the precedent of making bad loans good. Or the ECB could ignore the local crisis and let Spain pay the consequences. This alternative risks Spanish resentment of the central bank and its partners. And it also risks the transmission of the crisis to the rest of the Eurozone, for financial panic in one region of a currency union can rarely be segregated from the rest.”

The conclusion of many economists at the time was that the introduction of the single currency was far less based on economic logic than political logic. The idea of more stability, trade and employment was economically overemphasized for political and commercial reasons. But it is also important to understand that the EMU was the response to a changing economic reality due to capital mobility and the internationalization of economies, which started in the 1980s. A pure national macro-economic approach would be less attractive in such circumstances. In that context, it is especially interesting to look at the European social democrats who played such an important role in embracing the EMU in the 1990s. But why would social democrats want a single currency, as the EMU strategy is not about creating maximum employment and demand policy, but focuses on low inflation and supply policy? The answer has been reconstructed in the book Social Democrats and the Monetary Union (2001). It is suggested in this book that the social democrats did not belief anymore in Keynesian answers that were profoundly nationally oriented: ‘Owing to the rapidly increasing degree of capital mobility, the national models of Keynesian demand management became increasingly unworkable’.

There was an ‘absence of agreement amongst European social democrats that EMU should be employed as a means to reconstruct the post-war welfare state Keynesianism at the European level’. The Labour Party under Tony Blair argued that Keynesian strategies belonged irretrievably to the past. Labour’s Third Way philosophy became influential among other social democrats. German, Finnish, Dutch and Spanish social democrats made no mention of Keynesianism in their strategies for economic management under the EMU. Rather than eliminating unemployment, expansionary demand management provoked exchange rate instability. Being under constant surveillance by international mobile investors, the policy-makers of the European Union chose to orient themselves towards the stability-oriented policies of the EMU, which were based on the low-inflation practices of the German Bundesbank.

Denmark and Sweden were among the only countries in which there was a fierce debate at the top of the social democratic party and reservations about the idea of joining the EMU. These discussions resulted in referendums that were won by the ‘no’ side. That the UK under Labour opted out of the EMU was not based on disagreement on the economic strategy, but on losing sovereignty and the Sterling, a symbol of national pride. The UK traditionally takes a critical stance against any EU policy that gives more power to Brussels. The Conservative Party during the 1980s and at the start of the 1990s just wanted a single market. The idea of the euro was, under Prime Minister John Major, received sceptically. He adopted a ‘wait and see’ policy. With the electoral win of Labour in 1997 under the leadership of Tony Blair, this changed into a ‘prepare and decide’ policy. The UK government was less euro-sceptical and started a process of five tests to see if introducing the euro would be in favour of the UK. For more information on the UK’s stance against the EMU, read Rebecca Adler-Nissen’s book (2014) Opting out of the European Union: Diplomacy, Sovereignty and European Integration.

Overall, it can be concluded that in all countries (and within countries) the different political parties had their own favourable ideals about the single currency, more political integration, more trade and economic prospects, low inflation and attractiveness to investors. And, it was a commonly held belief that the EMU was the way to deliver these things.

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