Select Committee on European Union Thirteenth Report

CHAPTER 1: The Development and Growth of the Euro

Introduction

1.  The euro was created on 1 January 1999, when it was introduced as a legal currency and the exchange rates of the participating countries were irrevocably fixed to it; simultaneously the European Central Bank assumed full control of monetary policy for the euro area. The establishment of the single currency was the product of a long period of experimentation with other means of controlling exchange rate fluctuations, latterly through the exchange rate mechanism (ERM) of the European Monetary System.

2.  This Committee last examined the euro in 2003[1]. The approach of the tenth anniversary of the European Central Bank's foundation is an appropriate time to reflect on developments in the past decade. This report is not about the United Kingdom's position with respect to the currency, and we also think it inappropriate to reach conclusions on the impact of current liquidity shortages in financial markets as we took evidence before these issues became apparent. We will return to this issue when markets have stabilised. Our focus is on the mechanisms and institutions which govern the economic and monetary union (EMU), and the union's impact to date on trade, the capital markets, and economic growth in Europe.

The Development of the euro

3.  Following the establishment of the exchange rate union in 1999 the currency was given physical form in January 2002 when euro coins and notes were issued for the first time. The efficiency of this massive logistical exercise has rightly been praised. The size of the euro area increased from the original 11[2] to 12 with the accession of Greece in 2001, to 13 with the accession of Slovenia in 2007 and to 15 with the accession of Cyprus and Malta in 2008. A further five countries[3] have joined the ERM II arrangements, membership of which is a step on the way to full membership of the EMU. The euro area is thus now of considerable size and diversity, and its members contribute 72% of EU Gross Domestic Product (GDP).

4.  Externally the euro has established itself as a significant world currency and acquired the credibility that is necessarily absent from a new currency. The currency's early decline against the dollar and sterling has since been reversed[4]. The impacts on trade and the European capital markets to date (reviewed in Chapter 3) appear to have been substantial, although it is not possible to determine to what extent these effects might have occurred had other policies been in place.

5.  As the euro has established its global credentials, this report also considers the various adjustment problems that the euro poses for individual member countries. Indeed it is the nature of these adjustment problems that has prompted from the beginning a variety of critical comment on the viability of the monetary union[5]. The fact that, so far, the more extreme predictions have not been realised does not in itself prove that the underlying analyses were wholly wrong. The monetary union could still be tested by sufficiently large and persistent external shocks.

6.  The diversity of the Union and the variety of adjustment problems that this implies strongly coloured the evidence we received. Monetary policy in a monetary union is set centrally for the currency area as a whole and cannot be regionally differentiated. This means that at any point in time the monetary policy that is right for the Union as a whole will not be right for each and every individual member country (as indeed is the case in a national currency area within an individual country's borders). How much this matters depends among other things on the extent of the diversity of the Union and on the availability of alternative means of stabilization. Among the latter are fiscal policy and the flexibility of labour and capital markets.

7.  Some countries may be better than others at responding to the challenges involved: Professor Goodhart, of the London School of Economics, for example commented that Germany "is a very difficult country to live with", referring to the adjustment that Germany has successfully undergone in recovering its competitiveness (Q 7). While this comment implies admiration for the way the Germans have held down their labour costs it also highlights the difficulties that remain for other Member States who may be less effective at improving their competitiveness.

8.  Pedro Schwartz & Juan Castañeda of the Universidad CEU San Pablo in Madrid and the Universidad Nacional de Distancia, Spain, also stressed the fact that membership of the euro area removes the balance of payments constraint on investment (and spending in the country more generally) and typically reduces the interest rate facing borrowers below what it would otherwise have been[6] (p 70). Whilst this means that investment opportunities in any eurozone country are substantially free to be exploited by the import of capital from elsewhere in the euro area, this may at the same time be accompanied by substantial inflationary pressures on domestic prices. In the long run this would imply that the country loses competitiveness; it is no longer able to correct this by a devaluation of its exchange rate and can only adjust through restrained fiscal policies that will bear down on domestic cost pressures and employment. Portugal and Greece were cited by witnesses as prone to this problem. Italy was cited as a country which had been particularly badly hit by a lack of demand in external markets and was finding the required adjustment difficult, complicated by the burden of its public debt (QQ 7, 92-94).

Future growth of the euro area

9.  The enlargement of the eurozone is seen as a sign of the strength and sustainability of the euro; new Member States wish to join because they consider that the benefits outweigh the costs. All new Member States are bound by their Treaty commitments to join the eurozone as soon as they satisfy the criteria and are deemed eligible to do so[7].

10.  Professor Dr Norbert Walter, Deutsche Bank, considered that the eurozone's expansion should allow the entire zone to benefit from the economic growth that new Member States experience on joining the EU and the eurozone (p 77). He added that this should not be overstated: the impact of the nine potential additional members on the eurozone economy will be limited as their overall economic size is only 7% of the existing eurozone's GDP and the more prosperous potential members are not expected to join the eurozone in the near future.

11.  It was impressed upon us that there is no need to rush the process of enlargement of the eurozone and countries should not be allowed to join for purely political reasons before fulfilling all the criteria for entry (Bruegel p 57). Premature entry could be counterproductive and have adverse effects both for the country entering the zone and for the eurozone as a whole. The adjustment period for some of the new Member States is expected to be as difficult as it was for some of the existing members; new members will thus have to ensure that their monetary and fiscal policies in the build-up to accession will provide them with the necessary cushion that accession to a monetary union with the structural particularities of EMU requires.

12.  The entry criteria[8] are seen by witnesses to be fair when taken as a whole, although the inflation criterion in particular is considered too restrictive on economic growth and difficult to meet in high growth countries such as the Baltic States, especially in conjunction with the exchange rate stability criterion (Professor Portes, London Business School Q 169). Estonia, for example, had satisfied other criteria for entry to the eurozone on its accession to the EU but withdrew its application because of concerns that it would not meet the inflation criterion. It has been suggested that candidate countries should be required to meet an average of the inflation rate in the three euro area countries with the lowest inflation rather than the harder target of the average of the lowest three rates in all EU Member States (Wickens, Portes QQ 82, 170) as is required at present. The Committee is sympathetic with this point of view but it is essential that new countries enter at the appropriate inflation rate; otherwise, if a country comes in with an inflation rate that can not be sustained in the medium and long term, the effect on the eurozone in general and interest rates in particular will be negative.

Our inquiry

13.  The membership of the Sub-Committee that undertook this inquiry is set out in Appendix 1. We are grateful to those who submitted written and oral evidence, who are listed in Appendix 2; all the evidence is printed with this report. We thank the Library of the House and HM Treasury for their advice on sources of data for the figures. We also thank the Sub-Committee's specialist adviser, Professor Michael Artis of the University of Manchester. We make this report for information.

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1   European Union Committee, 42nd Report (2002-03): Is The European Central Bank Working? (HL 170) Back

2   Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain. Back

3   Denmark, Estonia, Latvia, Lithuania and Slovakia. Denmark has an opt-out from full membership of the single currency. Back

4   Illustrated in Figure 6, page 23. Back

5   Many economists predicted that the eurozone members would not be able to reach agreement on monetary policy. In his paper EMU and International Conflict (Foreign Affairs November/December 1997) the American economist Martin Feldstein set out a hypothetical scenario of how policy disagreements within the monetary union could result in the acrimonious collapse of the European Union.  Back

6   The removal of any apprehension that the currency might be devalued implies that investors from one eurozone country looking to invest elsewhere in the zone need no longer take into account any devaluation risk. This simultaneously removes the need for an interest rate premium to compensate for such a risk.  Back

7   Only members of the EU are eligible to join. Newer Member States who are yet to join are Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania and Slovakia. Sweden does not have an opt out but citizens voted in a 2003 referendum against joining the currency union. The UK and Denmark have an opt-out from the relevant provisions of the Treaty, although the Danish Prime Minister announced in November 2007 plans for a referendum on the subject within the next four years. Back

8   The criteria are set out in Article 121 of and a Protocol to the Treaty establishing the European Community. The criteria have not been changed by the Lisbon Treaty and will form Article 140 of the Treaty on the Functioning of the European Union. Back