The European Economic Community And The Euro Dollar

.. ally guaranteed because Euroland now possesses the most independent central bank in the world, the European Central Bank (ECB). Central banks steer a country’s inflation rate by using a variety of monetary policy instruments to lower or raise the general level of demand. The more independent a central bank, the less likely it is to succumb to the political pressures of its government to allow an economy to grow too fast or to finance excessive public expenditures which in turn leads to lower inflation. Yet history has shown that the central banks of many Euroland countries are not immune form political influence. That is precisely why the euro may be able to maintain long-term regional stability.

Lower interest rates are another one of the larger economic goals that the EEC is hoping that the euro will achieve. To the extent that the euro lowers inflation, it also exerts downward pressure on interest rates. Investors buy bonds only if they are sure that the money they receive in the future will result in a percentage return that is higher than the inflation rate. Investors consequently demand lower interest rates from countries with greater price stability. This benefit is particularly important for countries with poor inflation-fighting records.

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These countries now benefit form reduced inflation expectations because of the tight goals and determination of the new European Central Bank. Also, the euro brings lower interest rates by reducing exchange rate risk. The euro encourages structural reform in Europe. Countries wishing to qualify for the euro had to push their economies into shape by meeting the convergence criteria set forth in the Treaty on European Union. The criteria outlined in the treaty are: countries must have a rate consumer price inflation no more than 1.5 percent above that of the three countries in the EU with the lowest such inflation; countries must have a ratio of general government borrowing to GDP no greater than 3.0 percent; countries must have a ratio of gross government debt to GDP no greater than 60 percent; countries must have a nominal interest rate on long-term government bonds no more than two percent above that of the three EU members with the lowest such rate; and countries must be members of the European Monetary System and their currencies must trade within the normal margins of fluctuations of that system. This criteria was created to ensure that any country joining monetary union was fiscally responsible and that participating countries agree to a single monetary policy.

In the future, countries that have qualified to be a part of Euroland must adhere to the Stability and Growth Pact, an agreement that strictly limits government borrowing and forces governments to shape up their public finances. The pact also fines countries that borrow too much. “The euro is modernizing European economies, shrinking the size of their welfare states, and encouraging a modern, global view.” There exists the possibility that the euro will become a major international reserve currency. Reserve currencies are use by central banks, governments, and private firms worldwide as long-term store of value and to meet their ongoing financial requirements. The dollar is currently the world’s premiere reserve currency. Historically only currencies that are highly liquid, stable, and accepted as payment in a large economic area have the potential to become major reserve currencies.

Reserve currencies are highly demanded and therefore benefit from high liquidity and extremely low transaction cost in foreign exchange markets. Reserve currency status similarly benefits a nation’s securities markets, because buyers interested in holding a reserve currency buy assets denominated in that currency. This in turn lowers the cost of borrowing for firms and governments raising money in that currency. The advantages of having a currency, which is used as a unit of account and a medium of exchange in the rest of the world, are significant. There are two benefits. First, when a currency is used internationally, the issuer of that currency obtains additional revenues.

For example, in 1999 more than half of the dollars issued by the Federal Reserve were used outside of the USA. This doubles the size of the balance sheet of the Federal Reserve. Therefore the profits double and go on directly to the US government. In turn citizens enjoy the benefits of the worldwide use of the dollar in the form of lower taxes needed to finance a given level of government spending. If the euro reaches the same level as the dollar, citizens of Euroland will enjoy similar benefits.

Also if the euro becomes an international currency, activity will boost for domestic financial markets. “Foreign residents will want to invest in assets and issue debt in that currency. As a result, domestic banks will attract business, and so will the bond and equity markets. This in turn will create jobs.” Therefore if the euro becomes an international currency like the dollar, there will likely be the creation of new opportunities of financial institutions in Euroland. Finally, the euro has also encouraged economic growth within the European Economic Community.

Lower transaction costs and exchange rate risk, coupled with price transparency and a single means of payment, have increased the effective size of the product markets across euroland. As a result, some multinationals can now achieve economies of scale, which is “the ability to produce products at a lower average cost than competitors due high volume”. Economic historians know that economies of scale have been a key determinant of the United States industrial success for centuries. Euroland now hopes to benefit form the lower average costs, higher productivity, and enhanced competitiveness promised by a large internal market. Although the euro has proven to be successful since it was integrated in January 1999, there are two major ongoing risks associated with monetary union. These risks are not one-time costs that will soon disappear.

Instead, they will threaten the sustainability of the euro for decades to come. These shocks involve susceptibility to economic shocks and political discord. Economic shocks are “unexpected changes in the macroeconomic environment of a country or region that disrupts the careful balance of production, consumption, investment, government spending, and trade.” The most threatening type of economic shock for the single currency area is known as an asymmetric shock, so called because such shocks affect countries unequally. They can be caused by sharp declines or increases in demand for the primary goods and services of a specific country. “Before the arrival of the euro, Euroland countries could handle asymmetric shocks and the recessions that often followed them in three primary ways: interest rate adjustment, exchange rate intervention, and fiscal adjustment.” Of these, interest rate adjustment was the most important. The euro, however, makes independent interest rate adjustments impossible, because Euroland’s national central banks surrendered monetary policy authority to the European Central Bank in Frankfurt as of January 1999. There is now a single set of short-term interest rates for all euro participants.

Therefore, unless economic shocks hit all eleven countries part of the Economic Monetary Union simultaneously, interest rate adjustments cannot be used to manage them. The second major way in which economies recover from asymmetric shocks is through exchange rate adjustments. Yet for individual countries, the euro eliminates this monetary policy instrument, because the euro is now the common currency for eleven different countries. Therefore, currencies can no longer be devaluated at the national level. Another way in Euroland economies dealt with asymmetric shocks before the euro was through fiscal policy adjustment. Usually, when asymmetric shock send a country into recession, government spending increases. As a result governments go into debt during difficult economic times so that they can spend more money on social programs.

Such spending introduces large amounts of money into an economy, increasing consumption and economic growth once again and pushing the economy out of a recession. However, the euro restricts such fiscal stabilizers because members must adhere to the new Stability & Growth Pact, an agreement which requires all Euroland government budget deficits to be less than 3.0 percent of GDP. Therefore, it is evident that the euro has three primary impacts on the ability of countries to respond to asymmetric shocks: “it precludes independent interest rate movements: it prevents currency devaluations; and it restricts the ability of government spending to stabilize and economy.” There is a second major ongoing risk to monetary union. It stems form the fact that European political integration is still not complete. This poses two significant threats to the euro.

The first is that member governments may become financially wasteful. This endangers the viability of a single currency. Any single authority does not directly control the daily spending habits of the eleven members. Therefore, some nations may exceed the annual budget deficits outlined in the Stability & Growth Pact without notice, refuse to pay their fines, and become political outsiders to the union. “In this way, fiscally conservative and stable countries may be hurt by the excessive borrowing of others, because the excess demand non the capital market of a heavy borrower push up the cost of borrowing for everyone else borrowing in euros, even though distinct national interest rates still exist.” As a result this may destabilize all Euroland economies.

The euro officially came into being on January 1, 1999 under the full leadership and support of eleven heads of state, thousands of politicians, and hundreds of prominent economists. Whether the euro’s economic advantages outweigh the risks posed by economic shocks and political instability is unknown. The great gamble the EU (European Union) leaders have taken is that modern Europe is entering a new era of adaptability and flexibility that ensures the success of monetary union. So far the advantages of the EMU have come through and are showing positive signs towards the probability of a well-stabilized European economy that will benefit not only domestically but also internationally through economic stability, reform, and growth. Although its success cannot be determined until the next economic downturn, the EMU (Economic Monetary Union) is one the most exciting economic events in recent history. English Essays.


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