The Euro and EU Economic reform-the jury is still out

The Euro and EU Economic reform-the jury is still out

The main problem of the new currency is that is not founded on a state, argues Stefan Brill, leaving wide room for speculation about Member States’ true commitment to it.

There is no doubt that the introduction of euro notes and coins represents a milestone for European integration and the positive psychological effect should not be underestimated. Europeans have often identified with their national currency (which is still the case in Denmark and the UK). It was therefore surprising to observe the widespread acceptance of the new currency after the earlier strong resistance.

With the introduction of the euro in 1999, speculative attacks on the currencies of member countries of the type that occurred in 1992 came to an end. But the euro is not necessarily protected from all other forms of financial or capital market turbulence. The main problem of the new currency is that it is not founded on a state. It is based on a Treaty between the Member States leaving room for speculation about the commitment to it, at a time of crisis, which could culminate in a confidence game between Member States and the markets. After being in force for three years, it is time to examine the performance of the new currency in order to derive lessons for future steps towards integration.

The decline of the euro in world markets since its introduction in 1999, especially against the US dollar, is an issue of major concern for the single market project. The falling exchange rate combined with oil and food price shocks fuelled inflation, and the world economic slowdown led to lower growth prospects, making life for politicians even more difficult. This was even more problematic as analysts had predicted a euro/dollar parity when launching the new currency. No one appears to have anticipated the magnitude and speed of the slowdown both of the euro and the growth prospects of the European economy in general. Various reasons have been put forward to explain these developments. While there is not room to analyse all the arguments, some critical remarks can be made about certain common factors.

The common factors myth

One of the most famous – although not new – arguments concerns market disturbances in European countries. Extensive and overly costly social welfare policies and labour market rigidities are often mentioned, as well as the inability to establish sound fiscal policies. Although these arguments are unquestionably right and the rigidities do exist, it is difficult to make a direct connection with the exchange rate development of the last two to three years. One has to distinguish between long-term and short-term fundamentals, and these policy fields clearly belong to the group of long-term fundamentals. The weakening of the euro over the past years would therefore mean that any change that occurred has made the prospects more unfavorable and markets more pessimistic about the future. Looking at the facts this is certainly not true as these market rigidities existed long before. On the contrary, the pace and the speed of structural reforms undertaken in European countries has increased and the outlook therefore should be far more optimistic than a decade ago. Furthermore the euro did not strengthen when the US economy slowed down recently.

Other arguments that try to explain the weakness of the euro are the oil price shock and other more indirect, political factors. The oil price shock correlates perfectly to the euro depreciation and an often-mentioned argument is the high abundance of oil imports of European countries. But it has to be questioned how far this can serve as an argument for the depreciation against the dollar as the US is also an oil importing country. According to a study by Hunt et al , a 50 % increase in world oil prices would lead to a fall of the euro aga inst the dollar by only 1 percent. Political events such as the Danish and UK decision to stay outside euroland are difficult to measure. But it seems to be more logical that these countries stayed out because of the euro’s weakness rather than the other way round.

This opens the way to a boarder discussion about the impact of the introduction of the euro on the capital and financial markets within the region which might have caused major changes in the investment behavior of market participants.

Shifts in portfolio investment patterns

The integration of formerly national markets may have led to a shift in investors’ portfolio decisions as the differentiation between national and foreign investments changed . Securities previously considered as foreign assets, now may have been considered as domestic currency assets under the single currency. An unchanged portfolio combination of domestic and international currency assets would therefore lead to more investments outside the euro area and, consequently, a depreciation of the euro. As well as these possible shifts in portfolio decisions within the euroland area, some shift in international portfolios can be observed. The introduction of the euro seems to have given a significant boost to intra-euro area flows. While investors from within the euro area appear to have widely accepted the new currency, the forecast capital inflow from foreign investors did not materialize.

The lowering of barriers to cross-border financial transactions has led to more liquid markets in euro-denominated debt securities and an increasing issuance of corporate euro-bonds. Bond markets, corporate and national, were highly influenced by the euro mainly because of its international character even before its introduction. Although the increase in issuance volume cannot be attributed to the new currency alone, the ECB calls it a success story.

One can say that the euro – according to its underlying economic fundamentals – does seem to be undervalued. The problem is that, as far as investment decisions made by international investors are concerned, the relevance of macroeconomic fundamentals is declining. Investment decisions are increasingly based on investors’ sentiment and behavior rather than on hard economic facts. The weakness of the euro may well reflect market participants’ expectations that productivity growth in the US will remain stronger than in Europe as Alec Greenspan put it recently.

Urgent need for reform of the financial markets

What has to be done to enhance growth and improve productivity was clearly defined in the Lisbon summit declaration. As regards EMU, one can state that economic union clearly lags behind monetary union. Financial markets in Europe for example are still largely fragmented. Financial market integration as one of the cornerstones of Lisbon is of utmost importance and is laid down in the Financial Services Action Plan prepared by Alexandre Lamfalussy. It is critical to making full use of the high growth potential in Europe.

After just one year in force, this plan is – apart from the commitment of all the major political parties – lagging behind its schedule. Indeed the issue nearly caused a constitutional crisis within the union in the past months. Lamfalussy himself harshly criticized the involved political institutions for blocking the process and not understanding the importance of a fast procedure. This plan will prove the effectiveness and efficiency of all European parties and their commitment to full European economic integration. A failure of this plan would mean a major setback to the integration process as a whole.

It is unnecessary to talk about the need for a European government or state to ensure the success of the euro. In any event before thinking about any further political integration Europe needs to develop an economic union. As mentioned already, the euro is a currency without a state. Therefore there is a strong need for closer policy coordination and cooperation to achieve the goal of a single market and far more importantly, to preserve the new currency from becoming a target of speculation. Markets will be very cautious about the credibility of the euro. This credibility depends, above all, on the commitment of the Member States to the Stability and Growth Pact and it remains to be seen whether the creation of a monetary union will enhance structural reforms and fiscal stability or rather reduce it.

Stefan Brillis an executive of the Financial Services Action Plan Forum and The European Policy Centre
Hunt et al. (2001), The Macroeconomic Effects of Higher World oil Prices, IMF Working Paper WP/01/14
Galati et al. (2001), The Impact of the Euro on Europe’s Financial Markets, BIS Working Paper, No. 100

For more in-depth analysis, see The European Policy Centre’s website:

The Euro and EU Economic Reform – the jury is still out.