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The euro: laying down the challenge
by Patrick Lenain, Economics Department
After years of preparation and debate, the euro banknotes and coins have finally arrived. Since 1 January cash dispensers in the 12 member countries of the euro zone have provided crisp euro banknotes instead of national currencies, and all payments by credit card, cheque or transfer have had to be made in euros. Any national currency banknotes and coins left could be spent in parallel before losing their status as legal tender, generally by the end of February 2002.
The introduction of euro cash has important symbolic and political dimensions. It is the realisation of a dream that has long been expressed by political and other visionaries — Victor Hugo wrote about the "United States of Europe" — and is a key step in the construction of Europe as articulated by founding fathers such as Jean Monnet and Altiero Spinelli and political leaders like Konrad Adenauer, Robert Schuman and, most recently, Jacques Delors. As the bridges displayed on all euro notes suggest, the single currency is expected to link countries from Finland to Spain and from Ireland to Austria more closely together. The notes also display windows and gates that symbolise the passage to a new era.
But what sort of era will it be? In 1990, the European Commission published a report entitled "One Market, One Money", but is there really one market in the euro area? And how can a single monetary policy operate in a zone where sudden changes, whether in business sentiment or monetary conditions, can lead to asymmetric shocks which affect some countries and regions more than others?
Euro Economics
The circulation of euro notes and coins is the end of a long process of monetary integration. The most important step in this process was made three years ago, when exchange rates between the euro area’s member currencies were irrevocably locked. This established the final framework of Europe’s monetary union, with major repercussions, not least of which was the elimination of currency fluctuations within the euro area and the introduction of a single monetary policy. The bulk of non-cash financial instruments (shares, bonds, mutual funds, time deposits and bank accounts) were converted in 1999 or shortly thereafter. By comparison, the recent substitution of notes and coins, which constitute only 7% of M2 money supply, has more limited economic implications.
Nevertheless, the logistics of the switch were formidable: 50 billion new coins were minted and 14.5 billion new banknotes printed, all of which had to be delivered to the right place at the right time, for a total value of Ä664 billion. Cash dispensing machines had to be adjusted, computers reprogrammed and soft-drink vendors and pay phones adapted. The overall cost of the changeover (transportation, security, training, software adjustments and so on) is estimated to have run into the several billions euros, although no precise estimate is available.
The cost is also being borne by retailers and customers, who have had to post prices in the single currency or grapple with new monetary symbols. Although banknotes are identical throughout the euro zone and coins have a common side, the flip side of the coins is minted with symbols specific to each country, adding to initial confusion as the money spreads across member borders. Some 120 different types of coins are in circulation at the same time (12 series of eight coins issued by each member state, plus the Vatican, San Marino and Monaco), enough to cause headaches for at least some of the 305 million inhabitants of the euro zone. A temporary jump in prices is also likely to have happened, with retailers taking the opportunity to round up prices on conversion.
For all their effort in getting used to new prices, notes and coins, what benefit can Europeans expect to draw from the changeover? One gain often highlighted is the elimination of commission charged on foreign exchange transactions. Yet most of these charges were already eliminated in 1999, so that the new coins and notes will mostly be welcomed by tourists who no longer have to change their money to visit different member countries. On the other hand, the single currency does not mean a single banking system and, though the European Commission has compelled banks to eventually bring fees for intra-euro zone transfers into line with those for domestic transfers, for now cross-border bank transfers from, say, Greece to the Netherlands, will incur costly handling charges as before.
Another much boasted benefit of the changeover is more price transparency: having one currency exposes price differentials between countries, helping consumers and firms compare prices and forcing suppliers to be more competitive. In fact, the shortcomings of the single market have so far limited price convergence. According to the William M. Mercer Global Information Service, the price of the same litre of milk ranges from Ä0.67 in Portugal to Ä1.22 in Italy, while the price of the same colour TV ranges from Ä543 in Finland to Ä1049 in Luxembourg. Taxes may explain some of these differences, but insufficient market competition is also responsible. The greater transparency brought by the single currency should help narrow the gap. Indeed, several magazines and newspapers already post the same price everywhere in the euro zone. For convergence to happen more generally, further regulatory reforms will be needed to remove blockages in cross-border trade within the euro zone, for instance, in the automotive industry, where buying a car in another country is still discouraged.
Stability and Risk
More important than conducting cash transactions with the euro are the benefits and risks associated with the long-term process of monetary integration, especially the elimination of exchange rate fluctuations since 1 January 1999. Such stability is important in a continent that was often struck by currency market turbulence, most recently in the wake of German unification. The sharp economic slowdown experienced since early 2001 and the terrorist attacks of 11 September have left European currencies unscathed; one can but imagine the monetary tensions that might have occurred without the locking of exchange rates. By contrast, those European currencies outside the euro zone, including the British pound, the Swedish krona and the Swiss franc, are still subject to large fluctuations.
But there are risks to monetary integration too and doubts have been raised as to whether the euro area meets the conditions needed for the single currency to succeed. Monetary union brings its sacrifices, including the loss of autonomy with respect to exchange rate and monetary policies. To outweigh such costs, the economies sharing the same currency should not be too dissimilar, otherwise, it would be better to retain autonomous policy instruments. As matters stand, there is some evidence that euro zone economies react differently to common shocks (such as oil price hikes or world trade slumps), in no small part because uneven progress has been made towards labour market flexibility. Also, euro zone economies often appear to react differently to interest rate changes, and ECB decisions may therefore have different impacts on different countries. This may improve over time as economies adapt to the new monetary regime, and indeed recent research is reassuring on this point.
Still, specific shocks tend to affect the euro area in an asymmetric fashion, hurting some regions or countries more than others, and this may lead to divergence rather than convergence. Although the European Central Bank began controlling monetary policy for the euro zone three years ago, consumer inflation rates still ranged from 1.3% (France) and close to 5% (Netherlands) at the end of last year. Output growth has also diverged during 1999-2001, with cumulative growth of 8.5% in France, but only 5.5% in Germany. Several small economies, like Ireland, have been through periods of overheating, and could not raise interest rates to cool domestic demand growth or inflation. Also, the recent bursting of the Internet bubble is an asymmetric shock, affecting countries like Finland that are specialised in information and telecommunication products more than larger, more diversified, economies.
These dissimilarities are not an insurmountable obstacle to monetary union, but they require that member economies become more adaptable and adjust to shocks without relying on help from policy intervention. Budgetary policy of course remains in the realm of national government and can be used to respond to adverse developments, but safeguards enshrined in the Maastricht treaty to prevent excessive fiscal deficits restricting the margin of manoeuvre. All this implies that Europe will reap the full benefit of the euro only if it removes outstanding obstacles to the free flow of goods, services, capital and workers.
Unfortunately, economic integration has so far lagged behind monetary integration. Even in the much vaunted single market, important sectors are still protected by national barriers — banking and energy being just two. Large public subsidies continue to distort competition, not least in agriculture. Public procurement still favours national suppliers. The lack of labour mobility is also a problem. Whether for cultural, linguistic or institutional reasons, countries affected by adverse asymmetric shocks may suffer high unemployment, even if neighbours have a healthy labour market. Clearly, Europe needs to step up the structural reform agenda to which the European heads of state have expressly agreed. Today's currency union under the euro simply makes the objective of completing the single market more desirable than ever.
Reserve Currency?
Another long-term benefit of the euro often claimed by fervent supporters is that the single currency ought to become a more important international reserve currency than the sum of its legacy currencies. This would bring greater immunity from international financial fluctuations, as well as a more prominent role for Europe in designing the international financial system’s architecture.
But the euro’s performance in international markets has so far been disappointing. Since its launch in 1999 its exchange rate has declined by close to 25% in US dollar terms. And balance of payments data indicate that residents in the euro zone make more portfolio and direct investment outside the area than non-residents make inside it. Euro-denominated issues on the international market for bonds and notes still lag well behind those denominated in dollars. According to the Bank of International Settlements, during the first three quarters of 2001 gross international debt issuance denominated in US dollars came to $732 billion compared with only some $535 billion in euros. About half of outstanding amounts of international debt securities are denominated in US dollars, compared to a relatively modest 30% in euros. Central banks also preferred to keep 68% of their foreign exchange reserves in US dollars at the end of 2000, compared to just 12.7% in euros, according to the IMF annual report.
How to achieve a more internationally attractive euro is not clear, though making Europe a more attractive place to invest would be a helpful start. Surveys and business reports indicate that most of the euro zone remains stifled by cumbersome administrative regulations, rigid labour markets and high operating costs — although some progress has been made to address those issues. Investor caution may also reflect the problems of building political cohesion across Europe. After all, despite the fact that Europe has one money and a European Parliament, it is still represented by separate nations in international financial organisations like the IMF and the World Bank. It also sends separate delegations to international economic forums, such as those of the Group of Seven. With the euro, Europe will have to overcome these national prerogatives and speak with one voice in the international monetary arena. It will take work. But if achieved, and if single market reforms are pursued with the same determination and vision as for the euro, then the new currency will not only bring Europeans together, but will also become a harbinger for greater prosperity.
Patrick Lenain, OECD Economics Department
The 12 euro member countries are: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, and Spain (United Kingdom, Sweden, Denmark are members of the European Union, but for the time being have opted out of the euro).
References and Further Reading
Greenspan, A., "The euro as an international currency", Remarks before the Euro 50 Group Roundtable, Washington, DC 2001.
Koen, V., Boone, L., de Serres, A. and Fuchs, N., "Tracking the euro", Economics Department Working Paper No. 298, OECD Paris 2001.
Koen, V., ì2000: the euro’s annus miserabilis?î in OECD Observer No. 226-227, Summer 2001. See below.
OECD: EMU : Facts, Challenges and Policies, Paris 1999
OECD: EMU: One year On, Paris 2000
OECD: Euro Area, Economic Survey series, Paris, 2001.
Solomon, R., "International effects of the Euro", Policy Brief No. 42, Brookings Institution, Washington, DC, 1999.