20 Years of the Euro

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.

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Sterling and the UK Economy

The pound has undergone something of a roller-coaster ride over the past three and a half years.  It was $1.71 in July 2014, fell from $1.49 to $1.32 after the Brexit vote and then again to $1.21 in January, 2017 and has recently risen to $1.38 (20th January 2018). However, it is worth noting that while, historically we usually measure sterling against the dollar, the fall against the euro has been greater.  In July 2015, £1 would buy 1.49 euros but by August 2017 the rate had fallen to £1 = 1.08 euros  and it is currently at £1 = 1.33 euros.

This post will consider the factors which might cause the value of a currency to fluctuate. (and the next will discuss the impact fluctuations might have on an economy). Over the last 100 years, the world has moved from a system where currencies were fixed to gold (the Gold Standard), to a time when the dollar was fixed to gold while currencies such as sterling were pegged, with limited flexibility, against the dollar (the Bretton Woods Agreement) to a system of flexible exchange rates where, today, in theory, the demand for and supply of the pound in the foreign exchange market determines its value.

In old economics textbooks, the adjustment process was simple.  The demand for a currency is determined by foreigners wanting to buy UK exports and needing to pay for them in sterling while the supply of sterling came from UK firms and consumers wanting to buy foreign goods and services, such as overseas holidays, and needing to swap pounds for foreign currency to pay for them. If the UK had a balance of payments deficit, the demand for sterling in the foreign exchange market would be less than the supply and so the value would depreciate against other countries, making UK exports cheaper and imports more expensive, restoring international equilibrium.

Today the situation is far more complex; not only do we have to consider the impact of a currency such as the euro which has replaced the individual currencies of the members of the eurozone, making it impossible for them to use depreciation to improve their balance of payments, it is now no longer the sale and purchase of exports and imports of goods and services which determines  the exchange rate, it is the trade in financial assets which is far more important as banks, businesses, governments and individuals buy and sell foreign shares and government securities and move money between countries to gain higher interest rates or profit from speculative movements in currencies. To put this into perspective, the World Trade Organisation estimated that in 2015, total international trade in goods and services amounted to $20 trillion while $5 trillion was traded on the foreign exchange market EACH Day.

Therefore factors which influence speculators’ views of the economy will have a major short-term impact on the value of the currency. Hence, immediately after Brexit, the general view was that leaving the EU would have detrimental effects on the economy (or at least on those dealing in financial assets and currencies) and this reduced the demand for sterling from overseas and increased its supply from UK holders seeking to purchase foreign financial assets. Similarly if the political situation changes and that affects views of the economy, then the value of the currency will change. Other things which will affect the value of the currency will be changes (or expected changes) in our rate of interest or the rate of interest in other major currencies, the economic performance of our economy or other major countries since if, for example, the US economy weakens, then relatively, the UK economy will be stronger and this will encourage a movement of money from the dollar to the pound.