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Plan:
1) Definition, History
2) Success criteria = things that EMU needs to accomplish. Mostly to eliminate the inefficiencies arising from barriers to free markets. Arguably also improvement on efficient mkts.
a) Promotion of trade
b) Macro-economic stability (no competitive devaluations)
c) Volatility reduction – this is improvement to existing markets
d) Increase in liquidity – international reserve currency and all that.
3) Factors that could affect the criteria are thing that make the attainment of these impossible
a) Internal factors
i) Loss of political will to give up sovereignty.
b) Bad design – not an Optimal Currency area. OCA – much talked about. In reality, little evidence to support that states actually can manage their currency.
i) Bad management
ii) competition to lowest standards
c) External factors
i) World markets turmoil
ii) Asymmetric shocks.
d) Wrong priorities. Maybe they conflict with equality and long-term sustainability
i) Central banks going bankrupt.
ii) Income inequality increased
4) Conclusion - Seems like the challenges are mostly external, so they would occur either with or without EMU, thus EMU should go ahead.
a) Important factors
i) Political will is probably the most important challenge. Kohl and Deloirs gone. Thus, we could have another period of 70-s dead EU. However, Tony Blair yesterday very supportive
ii) Financial speculation – hard to imagine. The idea is that other central banks can actually print money for the bank under attack!
iii) No liquidity achieved if currency is not stable.
iv) Short-term challenge of Y2K and computer expenses. Structural UE.
European Monetary Union is the culmination of a project that has lasted for many decades after the Second World War. The Monetary Union was first tried with the Werner plan in 1960-s, which failed. It was followed by the ERM, that was a partial success and now Europe is in the middle of the final stage of EMU, which is likely going to succeed. Still, there are some dangers that the already introduced euro might have to be abandoned. Although the probability of this happening is very small, the costs associated with failure are enormous, thus the importance of this topic.
I will start by answering what is a successful EMU. Clearly, it must benefit its members more than the existing system. There are numerous ways in which EMU can accomplish this, and in order to understand the threats to the system, it is important to realise where the threats could occur.
The main aim of EMU is to facilitate trade. It destroys transaction costs, which are associated with crossing borders. It also allows consumers to compare goods in different countries, and thus eliminates price inefficiencies and monopoly pricing (e.g. at present cars are more expensive in UK than anywhere else). The benefits of trade are quite fundamentally established in economic literature, starting from Ricardian comparative advantage. Still, I will look at the problems that extra trade can create in terms of inequality and unemployment later.
An important aspect of EMU is also the fiscal prudence it forces on participants. Countries like France cannot repeat the competitive devaluations of 1980-s that were damaging and unfair to German industry. There is a stability pact attached to EMU, which forces countries to keep their budget deficits in a manageable deficit.
Finally, there are macroeconomic gains possible from reduced volatility and increased liquidity of euro. This point differs fundamentally from the previous two. Whereas the former policies were meant to secure a more free competitive market, this actually implies an improvement on the free market. By reducing volatility and increasing liquidity the risk of investing into euros is reduced. This translates into lower interest rates that help the countries to grow faster.
The second part of my essay deals with the possible problems that could affect EMU. I will go into more details about the most important factors in my last section. This allows me to compare the relative importance of the challenges more clearly.
First, there are internal challenges. Most important of those are the loss of political motives to carry out the EMU, or the bad management of the EMU by participating countries.
Previously, there were clear motives for both France and Germany to create the monetary union. France wanted to control the monetary policy management, which it was unable to do separately from the Bundesbank, given its relative strength. Germany on the other hand wanted to form a stronger union to indicate its willingness to co-operate in the light of the Second World War. One can argue that once euro is adopted, French will want to control it as much as possible. Similarly, Germany is now after the unification the biggest country in Europe and the extra legitimacy of a closer union is not essential. Thus, sustaining the political will could be a challenge. On the other hand, Tony Blair has recently presented strong arguments in favour of euro, and thus could continue pushing its development and enlargement.
Some writers argue that there will be internal challenges arising from the fact that EMU is not an Optimal Currency Area. However, recent evidence has shown (Eichengreen) that there is very little empirical evidence for the evils of not being an OCA. Furthermore, the theory of OCA was developed in a system where people were expected not to hedge their risk, which is surely a mistaken assumption at the moment. On the other hand, when people do hedge, there is no difference between having a currency union or floating rate, except the premium one has to pay for the futures contract. The premium, however, is always reduced to 0 in a credible monetary union, and this is the empirical result at the moment.
The final internal threat comes from the design to competition. Although I support libertarian ideas that tax competition to lowest levels is good and forces governments to become efficient, I do appreciate the point that competition is a major challenge to the governments, and may be they need some short (20 years or so) time to get use to being responsible (in the south). Although this challenge appears as economical and to do with motivation and social justice, the actual argument will be fought on political lines, and I do not wish to go too deep into those.
A second set of threats to the currency union arises from external effects. They are fundamentally different in a sense that despite their existence, EMU could actually be able to accommodate the shocks better, compared to no union, even if after the shock EMU would have to be abandoned.
The two main popular external shocks that everyone discusses are asymmetric shocks to just one participating country, especially as trade leads to specialisation, and shocks arising from overall financial market turmoil. However, we now already about the possibility of those shocks and thus, banks have likely taken all possible steps they could. Alternatively, they will be more able to do so in a free capital movement area like EMU. It is the shocks we do not know about that are dangerous, like innovations in financial products, or issues arising from computerisation of the society. However, as we do not know about them, they are hardly likely going to be challenges. There is no point in speculation (unless you want to get your name printed in a journal that is J).
What I think is the most important challenge is to do with both external and internal effects. The design of EMU concentrates on efficiency leaving out equality issues and sustainability issues. The argument goes that one can have redistribution more effectively by other means, still I think creating the other means in the presence of EMU is a big challenge. For example, the regional inequalities. At present the currency system allows for transfers to poorer regions by making their exports relatively cheap with devaluations. After EMU and explicit transfer system has to be agreed upon. This is unlikely going to be an easy exercise.
It seems like the challenges are mostly external, so they would occur either with or without EMU. In addition, it is not clear that the EMU would do much worse under these shocks, and as it has microeconomic benefits, it should go ahead. However, it needs political will to go ahead, and here where the main challenge lies. Kohl and Deloirs, the big supporters of federal Europe, have gone. Thus, we could have another period of 70-s dead EU. However, Tony Blair was very supportive to EMU last week, thus we might have some redistribution of political power occurring and interest in a federal Europe reviewed.
There could be some financial challenges if people do not take up using euro. It is hard to imagine what happens if speculation does occur. The idea is that other central banks can actually print money for the bank under attack which seems bizarre, but if done under the name ECB can actually work. The evidence so far is that fund managers are taking up euro, there is lots of liquidity achieved in the system and interest rates are historically low. Thus, it might well be that the most important challenges are short-term, to do with the Y2K problem and extra computer expenses to systems that recognise euro. This could create some structural unemployment as currency exchangers are fired etc. However, by the year 2002 when EMU completes, these transitional challenges should have disappeared, and we all live in a better place.