The state of the economy is bound to be one of the most discussed topics during the campaign ahead of the May 2014 European elections. In addition, the Eurozone membership is likely to be the target of criticism of Eurosceptic parties in Member States within this single currency area. So, in our eyes, it is particularly important to have a sound debate on the pros and contras of establishing and maintaining the Eurozone. After recalling the benefits of the Euro, we shall see the weaknesses of the Eurozone and the problematic consequences they have for some Member States with “weaker economies.” Finally, we will ask whether these Member States would have been (and would be) better off without the Euro: our answer is that this is not the case.
Assessing the adequacy of Eurozone membership requires, first of all, recalling the benefits of the Euro for its users:
- Price stability. Inflation in the Eurozone has been around 2-2.5% for most of the time since its creation. This was a positive change in some Southern European countries where the central bank’s commitment to limit inflation lacked credibility. Let us remember that inflation does not create real wealth but reduces the purchasing power!
- Protection against currency speculation. Until the 1990s, many European countries (including France and the UK) had to devaluate every now and then their currency to maintain some competitiveness compared to Germany.
- Protection against price volatility affecting oil and some other commodities. This advantage was particularly visible before the beginning of the financial and economic crisis, when the oil price and the price of some other important food commodities reached unprecedented peaks. A strong Euro mitigated the impact of the volatility of and strong increase in dollar-denominated price.
- A size effect. Prices can be compared across the whole Eurozone, allowing companies to choose the most price-competitive suppliers. Moreover, a huge monetary zone facilitates trade, financial and touristic flows between its members.
- Last but not least, the Euro is a political symbol marking a new step in an ever closer European integration (NB: an ever closer integration does not mean that everything is to be decided at central European level; a closer integration goes together with a firm application of the subsidiarity principle). Moreover, the Euro also continues to symbolise prosperity for a number of citizens in the poorer Member States in Central and Eastern Europe.
That being said, the Eurozone also has weaknesses due to the fact that it is not an optimal currency area.
The 5 main criteria defining the optimality are: labour mobility across the area; openness (free capital mobility, flexible wages and prices); similar economic cycles for all members; a redistribution mechanism to support the members adversely affected by the creation of the area; and similar/common political goals.
Thanks to the Single Market, the Eurozone economies have a high degree of openness (though flexibility of wages is lacking in many Member States). Moreover, their economies are sufficiently tied together to claim that they have similar economic cycles (or, at least, they had them before the beginning of the sovereign debt crisis; in the current situation, this assumption is challengeable). And it is also acceptable to say that Eurozone Member States have, to a certain extent, similar political goals based on common values and the European “Welfare State.”
However, the Eurozone still needs to make significant progress in matters of labour mobility (far too few European workers are active in another country) and in the setting up of a solidarity (redistribution) scheme, which is slowly underway.
The above-mentioned weaknesses in the Eurozone design have had some problematic consequences for Member States with economic structural weaknesses.
So, devaluation is not anymore possible to artificially regain competitiveness compared to countries like Germany. The consequence is that price-competitiveness can only be regained by making adjustments in the real economy, e.g., by cutting wages. Of course, these countries should also think about developing the quality and innovation of their products and services. Indeed, price is not the only factor of competitiveness!
Moreover, these Member States may try to delay hard choices with fiscal interventionism, thereby creating and deepening fiscal imbalances with the risk to eventually end up caught in a sovereign debt crisis like that experimented by the Eurozone.
So, would these Member States be better off outside the Eurozone, respectively should they never have become member of it? My answer is no.
First, while it is true that they could proceed to adjustments through devaluation and inflation rather than wage cuts, let us note that both methods have exactly the same effect on the spending power: a reduction in real wages.
Secondly, the positive effect on the balance of trade should not be taken for granted. Indeed, exports become more price-competitive, so that their amount shall increase, but as they are sold at a lower price, there is no guarantee that the total value of exports will rise. Furthermore, imports get costlier (leading to inflation) and shall thus decrease, but only within a certain limit since some imports (in particular, oil and food commodities) are unavoidable, regardless of the price level. So, a positive general effect on the balance of trade is far from certain.
Thirdly, many weaker European economies would have suffered far more during the financial and economic crisis, had they not benefited from the credibility of the ECB and the solidity of the EU and the Euro.
Fourthly, leaving the Eurozone now would entail high costs and an unpredictable shock for the economy of the Member State concerned by this measure. In particular, national money would have to be created and put into circulation. The newly created currency would face a heavy devaluation (notably for Southern European countries, France or Ireland) making fiscal adjustments even more necessary. As a result, the credit rating of a Member State leaving the Eurozone would most probably be significantly downgraded and this Member State would lose access to financial markets, making its financial problems even more stringent. The financial sector would face not only these difficulties, but also a flight of capital to countries considered as a “safe heaven,” as investors would not want to see their belongings devaluated. The Member State would probably have to save alone its banks, as the ECB and other Member States surely would not want to contribute anymore to a rescue. To sum up, the costs and risks of a Eurozone exit are certain and would be immediately faced, while benefits in the longer run are highly uncertain.
As a closing remark, it may be worth remembering that monetary and fiscal policies have different purposes and origins, and consist in diverse instruments. The Euro is not responsible for tax cheating, housing bubbles, a disproportionate development of the financial sector in some financial centres, or a reckless fiscal policy. Of course, the Eurozone’s functioning can and must be perfected, but the Euro only created a constraining framework which makes structural weaknesses more visible, it did not create them!