The Benefits of a Common Currency Essay
The Benefits of a Common Currency
These are difficult times for writing about a common currency, especially when you usually and particularly refer to a common currency in the European Union. The European monetary system, which was supposed to provide a stepping stone to the final stage of Economic and Monetary Union, shortly thereafter has broken down. By saying “broken down” I actually mean that the commitment to manage exchange rates within relatively narrow margins of fluctuation has been relaxed significantly. A common currency was referred as a useful final step to take after the essential one of locking exchange rates, but not an inescapable step in completion of the process. The adoption of a common currency has always been a point of argument and that is why so many reports have been written about that.
The report on Economic and Monetary Union in the European Community (Luxembourg 1989) is one of them. It is noteworthy to mention what exactly has been written about the idea of a common currency: “The adoption of a single currency might be seen – for the economic as well as for psychological and political reasons – as a natural and desirable further development of the monetary union. A single currency could clearly demonstrate the irreversibility of the move to monetary union, considerably facilitate in the monetary management of the European Union and avoid the transactions costs of converting currencies.” The benefits of a single currency are mostly situated at the microeconomic level, while the costs of a common currency have to do with the macroeconomic management of the economy.
Replacing some countries their national currencies and adopting a common currency can be set to lead to gains in economic efficiency. These gains in efficiency come from either the elimination of transaction costs, which is associated with the exchanging of national moneys, or the elimination of risk due to the uncertain future movements of the exchange rates. To begin with, the reduction of transaction costs is actually referring to not only direct, but also to indirect gains.
Firstly, I would like to mention what I actually mean by direct gains. Everyone should have, at least for one time, a personal experience of these transaction costs whenever he would like to exchange one currency to another. Fortunately, these costs have vanished from the time countries move to a common European currency. Consumers would not any more have to change money when travelling and would encounter less red tape when transferring large sums of money across borders.
It was estimated that a traveler who want to visit all twelve member states of the European Union, would lose 40% of the value of his money only in transaction charges. Once in a lifetime a family might make one large purchase or transaction across a European border such as buying a holiday home or a piece of furniture. A single currency would help that transaction pass smoothly. Recently there was another estimation of the gains, which were obviousdirectly after the elimination of transaction costs,by the European Community Commission and they actually found out that about twenty billion ECUs per year are saved by the elimination of transaction costs.
The transaction costs are like a tax paid by the consumer in exchange for which he gets nothing. For that reason banks have to deal with, a major for them, problem of transition and manage to find other profitable activities. That is the only way for the society to have an actual profit. The elimination of transaction costs offers also a gain in an indirect way. To be more specific, this elimination is responsible for the reduction of the scope for price discrimination between national markets. It is widely known that Europe had experienced that price discrimination before the most countries of Europe adopt as a common currency Euro and the reason was the segmentation of national markets.
Therefore, the adoption of a common currency benefits the consumers as they no longer need to hesitate to purchase goods in the countries where they are cheap. The reduction of the cost of buying and selling currencies combined with other measures could possibly create a single market in which price discrimination would find difficulty in penetrating. After all, according to economic theory, prices should act as a mechanism to allocate resources in an optimal way, so as to improve economic efficiency. There is a far greater chance of this happening across an area where a common currency exists. The existence of uncertainty about future rate changes usually is responsible for uncertainty about future revenues of firms.
Most people accept that this causes a loss of welfare in a world populated by persons who strongly avoid taking risks. This majority of people would likely want to take the more risky return if they were promised that it would be higher than the less risky. Eliminating the exchange risk decreases a source of uncertainty and should therefore increase welfare. Nevertheless, we should recognize that changes in the exchange rate do not only represent a risk, but they also create opportunities to make profits. It is known that when the exchange rate becomes more variable there is an even higher possibility of making very large profits. Furthermore, when the exchange rate becomes very favorable the firm thinks about the option of exporting.
Contrary, when there is an unfavorable exchange rate the firm does not think about taking that option. According to option theory the value of the option increases when the variability of the underlying asset increases. Consequently, the firm which has the option to export is in better place when the exchange rate becomes more variable. In addition, there is an area where more important benefits from a decrease of the exchange rate risk can be expected. Usually, exchange rate uncertainty leads to uncertainty about future prices of goods and services. At that point I would like to make clear that when I am referring to exchange rate uncertainty I actually mean the real exchange rate uncertainty, which is the uncertainty that is created when the exchange rate changes do not reflect price changes.
History has proved that large real exchange rate movements led to large adjustment costs, like happened in the American economy during the 1980s. A decline in real exchange rate uncertainty, due for example to the introduction of a common currency, can decrease these adjustment costs. As a result, it is easier for the price system to make the right economic decisions.Moreover, an increase in risk, due to price uncertainty, in general increases the real interest rate. This actually comes from the fact that when the expected return on investment projects becomes more uncertain, the investors, who avoid the risk, require a higher risk premium to compensate them for the increased riskiness of the projects. Additionally, in a riskier economic environment, economic agents usually increase the discount rate at which they discount future returns.
Therefore, exchange rate uncertainty whichleads to this kind of increased systemic risk also heightens the real interest rate. To sum up, the adoption of a common currency would eliminate the exchange risk and thereby would lead to a more efficient working of price mechanism. Even if this effect cannot easily be measured, it is likely to be an important benefit of the introduction of a single currency used by some countries. Many people believe that the elimination of the exchange risk can lead to an increase in economic growth. According to that point of view, the adoption of a common currency, which will cause the elimination of exchange risk, can be responsible for an, at some point, economic growth.
However, it is fair enough to say that very little relation has been found. Generally speaking, the increased variability of the exchange rates, and particularly the large as well as unpredictable variability of the real exchange rates, does not seem to have significant effects on international trade and investment. In other words, between the exchange rate uncertainty and the economic growth has not been found an extremely strong relation. There are, however, some possible explanations in order to understand the reason for that weak relation between exchange rate uncertainty and economic growth. The first one is that when there is a comparison between the experience of the European monetary system countries and the other countries nobody takes into account the fact that the exchange rate uncertainty within the European Monetary system countries, although reduced, has not been eliminated.
The second one is that the decrease of exchange rate uncertainty may not reduce the systemic risk. Less exchange rate uncertainty may be compensated possiblyby greater uncertainty of interest rate. As a result, firms that deal with a greater monetary zone may not on average operate in a less risky environment. Taking into account some more evidence I accidently discovered, I firmly believe that I could mention another good reason which supports that the adoption of a single currency could be such a good idea. Especially, I am referring to the fact that a single currency could be responsible for the elimination of competitive evaluation.
Between the two world wars, several European countries engaged in what became known as “competitive devaluations” when a devaluation in one country was matched by a devaluation in other countries. While such competitive devaluations have been avoided in the latter half of the century, the possibility that they might reoccur still exists. In fact, all devaluations adversely affect inflationary expectations in the devaluing country. Given the increasing scale of intra-European trade, any return to competitive devaluations would have devastating effects on European economies. This possibility of these disruptions disappears when a common currency exists. It is also almost a fact that the existence of a single currency can prevent some speculative attacks. To be more specific, when different currencies exist, there is also possibility of a speculative attack on one or more countries.
The problem is exacerbated when a fixed exchange rate exist, because speculators have a one-way bet. If currency they have bet against is not devaluated all they have lost is their transactions costs on the deal, whereas betting correctly can result in speculator gains. Governments can defend currencies against such attacks, but this often involves raising interest rates, which decreases business investment and stands as a barrier in front of economic growth. To the extent that exchange rate disruption is avoided, trade, investment as well as economic growth will be encouraged and there will be resource savings, as there is no longer necessary for the authorities to hold reserves of foreign currencies to defend the exchange rate.
The later will again have a positive impact on investment and growth. Generally speaking, if we look out in the world today we can see strong currencies such as Japanese Yen, the American dollar and at some extent Euro. It is a fact that America and Japan have both stronger economies and they also have more millions of inhabitants than Europe has. The fact that there is a common currency used in the most of European countries has actually been a rival to the “big two”. European Monetary Union had to be self-supporting and therefore they would have managed to survive without trading with anyone outside the European Monetary Union area.
The adoption of a common currency in European Union was, at least at the beginning, meant to break the absolute existence of America and Japan and create such a suitable climate for healthy and profitable trading among European countries. Speaking about the ongoing situation, it is important to refer to some, in my opinion, important points. It is clear that all some ongoing developments in the financial markets, for which the introduction of the euro has been a catalyst, are contributing to a more dynamic functioning of the euro area economies and to the growth potential of the euro area. The overall picture of the prospects for the euro area economy may seem at odds with the conventional wisdom that Europe is suffering from chronic deficiencies, which translate into persistently lower growth, employment and productivity than in the United States.
Clearly, the single market has already led to increased competition in product markets, as well as in the service sector. The rapid integration of the financial markets in the euro area is contributing to an unprecedented process of corporate restructuring and this is connected with a rather pronounced decline in unemployment. Jobs are indeed being transferred from the slow-growing sectors of the European economy into faster growing sectors. There is tremendous development in that European sector, and in certain segments Europe has already assumed global leadership.It may very well be that Europe today is in the situation in which the United States found itself five to six years ago, at the beginning of a protracted period of high growth, large productivity gains and improved labor market conditions.
Two important conditions are required for this: first, price stability, in order to provide a stable environment for efficient corporate management and investment planning, and, second, the flexibility of the financial and labor markets. The first condition is guaranteed by the monetary policy pursued by the European system, and, with regard to the second condition, much progress has already been made on financial market flexibility. Overall, nobody can deny that the adoption of a single currency has important benefits. Concluding, a common currency can be responsible for the elimination of transaction costs. This fact can not only affect the economy directly, but also indirectly as it could make it more difficult for firms to apply price discrimination.
Additionally, by reducing price uncertainty, a single currency can improve the allocative efficiency of the price mechanism and this can certainly improve welfare, although it is difficult to quantify this effect. The theory of optimal currency areas believes that for a currency area to have the best chances of success, countries involved should have similar business cycles and economic structures.
Moreover, the single monetary policy should affect all the participating countries in the same manner. There also should be no legal, cultural or linguistic barriers to labor mobility across borders. There should be wage flexibility, as well as there should be some system of stabilizing transfers. I believe that nobody could tell if the above characteristics are really in force as far as is European Union concerned. Maybe we have chance, a chance that gives us some time in order to think carefully about our next step. So, we do not have to waste it, don’t we?
* International Economics, Robert J. Carbaugh, 2008, South Western Congage Learning * Economics of monetary union, Paul de Grauwe, 2007, Oxford university press * Economics, Stephen Ison, Stuart Wall, 2007, Pearson Education Limited * Economics, Michael Parkin, Melanie Powell, Kent Matthews, 2007, Pearson Education Limited 2008 *
University/College: University of Chicago
Type of paper: Thesis/Dissertation Chapter
Date: 17 February 2017
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