The origins of the euro were set out in 1992 in the Maastricht Treaty, which set out the pathway to economic and monetary union (EMU). This involved increased co-ordination of monetary policy, more converged economies and then the establishment of the European Central Bank and a single currency. In 1999, the euro came into existence as an accounting tool and, three years later, it became a physical currency, the official currency of the Eurozone.
In order to be successful, a single currency requires that member countries are both in similar stages of the economic cycle and are converged in terms of key economic variables. This means they will respond similarly to external shocks such as rising oil prices or a major demand-side shock in the world economy and changes in interest rates will have a broadly similar effect on businesses and households in each country.
The countries joining the eurozone had to meet convergence criteria to join. These were:
- an inflation rate no more than 1.5% greater than the average of the 3 lowest countries
- long term interest rates no more than 2% greater than the average of the 3 lowest countries
- a stable exchange rate within the exchange rate mechanism (an agreement to limit the flexibility of exchange rates) for 2 years
- a budget deficit less than 3% of GDP and a national debt less than 60% of GDP or falling towards it.
The advantages of belonging to a single currency revolve round greater economic stability because there are no exchange rate fluctuations, leading to increased investment, including foreign direct investment, economies of scale and greater international trade, in line with comparative advantage. There are also lower costs since commissions paid when changing currencies no longer apply to members of the single currency (but still apply when trading with counties outside the single currency area). There is also greater price transparency which increases competition since it is easier to compare prices in different countries
The UK did not join because it believed that the disadvantages would outweigh the benefits. The key one was the loss of economic sovereignty. Not only did member countries lose control of their interest rates, there now being a single one set by the European Central Bank which might have different priorities to the UK government, there was also no possibility of adjusting the exchange rate to boost exports and cure a balance of payments deficit. This meant that adjustment to economic problems would have to be internal, via cuts to real wages, probably accompanied by higher unemployment, in order for a country to improve its competitiveness. Furthermore the UK government did not want to limit its scope for fiscal adjustment because of government borrowing restrictions. There was also the fear that the UK economy, because of its higher level of home ownership (and therefore more homeowners with mortgages), closer links with the USA and its role as an oil producer, was not sufficiently converged with the members of the eurozone. There was also the issue of losing the pound which weighed heavily with politicians.
So how has the eurozone done since it began? It survived the financial crisis and the debt crises faced by the PIGS, the weakest eurozone countries, (Portugal, Ireland, Greece and Spain), setting up a fund to provide support to members in difficulty. The currency has also been accompanied by a growth in foreign trade, with eurozone trade doubling between 1999 and 2008, (but we do not know what would have happened without it). Furthermore, it has grown from the original 11 members and now has 19 members -Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain. As the FT pointed out, “the euro has become the second most important currency in the world. It accounts for 36% of global payments and 20% of central banks’ foreign reserves, second only to the dollar. The euro is used by 340m people in 19 countries. Another 175m people outside the eurozone either use it or peg their currency to it”.
However there is a more pessimistic view. Joseph Stiglitz, a Nobel prize-winning economist, argued last year that the euro has not been that successful, when one compares its growth with that of the USA. He also argues that there could be a new euro crisis in the offing with high Italian government borrowing, continued inequality in incomes between richer and poorer members of the eurozone with the latter suffering from low growth and poor competitiveness. The Economist (5th Jan 2018) talked of the ECB being too restrictive in terms of its interest rate policy, low rates of growth and high unemployment among some eurozone members. How the eurozone will cope if interest rates increase in 2019 or if there is another debt crisis remains to be seen.