Euro and Negative Effect of Single Currency Exchange Rate and Interest Rate

¶ … Negative Effect of the Euro The major issue facing the euro as a single currency is the potential problems that EU nations may face in absorbing future economic shocks. This is largely due to the fact that unlike most monetary unions, the euro will not be governed by a central fiscal policy since most member states are reluctant to give up control of taxation and expenditure policies.

To compensate, euro countries are bound to observe fiscal guidelines laid down by the Maastricht Treaty of 1992 and the Stability and Growth Pact drawn up in 1997. The Maastricht Treaty defined criteria that entails annual budget deficits held to 3% of GDP and the gross debt-to-GDP ratio reduced to 60% in order to avoid excessive borrowing by member states. Subsequently the Stability and Growth Pact defined the penalty sanctions to be imposed on defaulting nations. The EU believed that these measures would result in greater fiscal discipline on the part of member states.

However, concerns on the negative effects of insufficient flexibility of fiscal policies within the EU continue. For one, it is deemed that unlike other federations where regional economic shocks get quickly stabilized through redistribution of wealth from a centralized federal budget, the EU budget is too small and lacks the benefit of uniformity in taxation and expenditure. The EU also lacks flexibility in wages and prices, a high degree of labor mobility and centralization of budget transfers.

In the absence of sufficient flexibility in fiscal policies, it is believed that this will impact the role of automatic stabilizers, and that countries that face deficits near the 3% limit will not be able to run counter-cyclical deficits in downturns. Such lack of budgetary head-room will result in restrictive policies at a time when the exact opposite is called for, leading in turn to prolonged recession (University of Dublin Web site).

These fears were justified when the euro-area economy weakened in 2000-01 with a slowdown in the global economy, increase in oil prices and the effects of animal diseases/weather related shocks to food prices within the EU.

The effects of these shocks prompted the IMF to advise the acceleration of structural reforms; labor market reforms; fiscal measures in taxation and benefit systems; integration of the capital markets; monetary policy designed to keep price stability and inflation rates in check allowing for interest rate cuts; and most important fiscal policies that sustain medium term budgetary consolidation without resorting to pro-cyclical policies that risk prolonging the downturn.

With reference to the last, the IMF pointed out that EU countries have typically resorted to policies that aimed at smoothening out fiscal balances, thereby delaying much needed underlying fiscal adjustment and running the risk of entering into a longer recessionary cycle (International Monetary Fund Web site). Efforts by the European Central Bank to guide the fortunes of the exchange rate of the single currency can also adversely affect some individual countries, as happened in October 2000.

Though the ECB's decision to increase interest rates was supposedly aimed at countering the effects of oil price increases and a weak euro, it backfired when the currency weakened even further. This, at a time, when the corporate sector in many EU member states were issuing profit warnings that should have actually called for a softening of interest rates (Guardian Unlimited Web site). Conversely, the euro as a single currency can also have negative effects even when it is strengthening.

Take the impact on the German economy as a result of the recent conflict with Iraq leading to the strengthening of the euro against the dollar and increased prices of crude oil. Analysts feared the loss of global competitiveness, further aggravated by the appreciation of the euro against the yen, would adversely affect German exports and that the possibility of cheaper imports putting a lid on consumer prices would not be realized since Germany obtained roughly half its imports from other EU countries (Dresdner Bank Web site).

The euro as a single currency also has negative effects on the exchange and interest rates of countries aspiring to join the EU. Take the case of the Middle and Eastern European nations who are facing the prospect of interest rates converging on the way to adopting a common currency, leading to high capital inflows from portfolio and direct investments, in turn pushing exchange rates up and more or less forcing the central banks of affected economies to cut interest rates.

Continuous appreciation of exchange rates of such countries affects the competitiveness of local industry consequently impacting their development curve. In combination with the economic weakness in Western Europe, this also puts a burden on labor markets and weakens exports. Hungary,.