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Eurozone

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The eurozone is a group of member countries of the European Union that have agreed to adopt the euro as their common currency, officially designated "the euro area". In recent years it has encountered unforeseen difficulties which have culminated in the eurozone crisis of 2010-12.

Its future is uncertain. Among the possibilities are:   an orderly resolution of the crisis;   the restructuring of - or default on - the public debt of some of its member countries;   or their departure from its membership. Some of its leaders advocate its conversion into a political union.

Overview

Contents

The eurozone was launched in 1991 as an economic and monetary union that was intended to faclitate transactions and promote economic and fiscal stability within the European Union. Its rules involved the adoption of the euro as a common currency and compliance with agreed limits on its members' public debt and budget deficits. Some member countries were enabled to increase domestic spending by borrowing from abroad because of the effect of membership on their creditworthiness; and some member countries suffered a loss of international competitiveness because increases in their unit labour costs could no longer be offset by exchange rate depreciation. In 2010, a crisis developed over increases in the budget deficits of the PIIGS countries (Portugal, Ireland, Italy, Greece and Spain) in the aftermath of the Great Recession. Loss of investor confidence in their government bonds raised doubts about their ability to continue to finance their deficits, and eurozone resources were used to provide financial assistance to Greece and Ireland. There followed further losses of investor confidence in the bond issues of Greece and Ireland, and in those of Spain and Portugal, and there were fears that the problem might spread to other eurozone countries.

The European Economic and Monetary Union

The decision to form an Economic and Monetary Union was taken by the European Council in December 1991, and was given legislative effect by the Maastricht Treaty of 1992.
Its principal features are:

- the adoption of the euro as its members' the single currency;
- the coordination of its members' fiscal policies, by the adoption of agreed limits on the magnitudes of their public debt and their budget deficits; and,
- the operation of a common monetary policy under the management of a single Central Bank.

Its principal institutions are:

- the European Council, which sets its main policy directions;
- the Council of the European Union which coordinates its policy and decides whether to admit new members;
- the European Commission, which monitors compliance with its membership rules; and,
- the European Central Bank, which determines its monetary policy.

Rationale

The three major objectives of the proposed monetary union were stated in a 1990 European Commission report[1] as microeconomic efficiency, macroeconomic stability, and equity as between countries and regions. The report forecast great improvements in the stability of prices, economic activity and employment, but the immediate benefits were expected to be small compared with longer-term gains resulting from the policy changes, and changes of private sector behaviour, that would be generated by the new rules. Efficiency gains were expected to result from the elimination of exchange rate uncertainty and transaction costs, and model simulations had suggested that, in comparison with the alternative regimes, it would have absorbed the economic shocks of the previous two decades with less disturbance to prices and economic growth. The authors of the report consider what is described as an "effective economic policy coordination function" to be a necessary condition for success, and stipulate a need for "convergence" in terms of inflation rates and fiscal balances. (The other forms of convergence considered by proponents of optimum currency area theory are not mentioned).

Membership

Entry criteria

The criteria[2] for eurozone membership set out in the Maastricht Treaty were:

- an inflation rate not exceeding by more than 1.5% that of the three best-performing Member States;
- a general government budget deficit not exceeding 3% of GDP and a public debt of less than 60% of GDP;
- a long-term interest rate not exceeding by more than 2% that of the three best-performing Member States; and,
- a stable exchange rate.

Membership rules

The original version of the membership rules in the Mastricht Treaty (The Stability and Growth Pact[3] [4], ) set the same limits upon member countries' budget deficits and levels of national debt. Following multiple breaches of those limits by Germany and France[5] the pact was renegotiated. The revised agreement[6] treats a budget deficit not greater than 3 per cent of GDP, and a public debt not greater than 60 per cent of GDP as targets rather than permitted limits, and provides for:

- a "medium term budgetary objective" for each member country that specifies margins within which the target values may be exceeded;
- an adjustment path for return to the target levels;
- procedures for determining and revising the country's budgetary objectives and adjustment paths: and,
- an "excessive deficit procedure", prescribing the actions required of a country whose deficit is deemed to be excessive.

And, in a further relaxation, some categories of expenditure were exempted.
The agreement empowered the Council to penalise any participating member state that failed to take appropriate measures to end an excessive deficit. Initially, the penalty would take the form of a non-interest-bearing deposit with the Community, but it could be converted into a fine if the excessive deficit were not corrected within two years.

The Treaty on European Union prohibits both the assumption of liability for the commitments of member and governments (Article 125) and the purchase of their bonds by the European Central Bank (Article 123)

Members

  • The original members of the eurozone are: Belgium, Germany, Ireland, Spain, France, Italy, Luxembourg, the Netherlands, Austria, Portugal and Finland;
  • Greece joined in 2001;
  • Slovenia joined in 2007;
  • Cyprus and Malta joined in 2008;
  • Slovakia joined in 2009;
  • Estonia joined in 2011.

Effects of membership

A monetary union may be expected to reduce the cost of transactions among its members by eliminating both currency exchange costs and exchange rate risks - and thus to increase their growth rates. It may also be expected to improve the creditworthiness of its otherwise less creditworthy governments if potential investors expect the union's other governments to protect them from default. Their improved creditworthiness may raise their countries' growth rates further by enabling them to undertake productive investments that they would otherwise be unable to finance. By 2006 it was evident that mechanism had conferred major benefits upon the economies of Ireland and Spain[7], and of Greece. On the evidence of a comparison of growth rates over the period 1999 to 2008 it appears that the economies of the other eurozone members as a whole did not grow any faster than those of the other members of the European Union.

A further effect upon the economies of member countries arose from the imposition of a common exchange rate for transactions with non-member countries. That meant that a fall in the international competitiveness of a member country's products could no longer be offset by a compensating fall in the exchange rate that governed their price to buyers in non-member countries. Without that offset, the inevitable result of a loss of competitiveness was an increased deficit in the country's balance of payments, paid for by borrowing from abroad. Also, the membership of less creditworthy countries such as Greece and Spain, may be expected to have held down the euro's exchange rate, to the benefit of the exports of high-productivity countries such as Germany. On the evidence of a balance of payments comparison it appears that, although there was a small surplus on the eurozone's balance of payments at the end of 2007, Greece, Spain, Portugal and Italy were running large balance of payments deficits, while Germany and the Netherlands were running large surpluses. That suggests the occurrence of large transfers of resources in favour of Germany and the Netherlands.

Monetary policy

The monetary policy of the eurozone during its first decade was conducted in accordance with accepted international practice. The remit given to the European Central Bank assigned overriding importance to price stability, but also required it "without prejudice to the objective of price stability" to "support the general economic policies in the Community" including a "high level of employment" and "sustainable and non-inflationary growth"[8].

In its initial response to the recession of 2009 the Bank lagged behind other central banks in the adoption of expansionary monetary policies[9]. It eventually made a series of reductions to its discount rate bringing it down to 1 per cent by the second quarter of 2009 . When it became clear that those moves had not achieved the intended easing of the credit crunch it was decided in May to adopt the controversial and largely untried policy of quantitative easing [10].

Fiscal policies

The Eurozone does not intervene in member governments' fiscal policies except to monitor, and attempt to enforce, compliance with the Stability and growth pact. Early breaches of the pact were followed by a renegotiation that relaxed its provisions, but there were some further breaches of the relaxed rules. In 2008, the European Commission warned that the eurozone's average public debt could reach 84 per cent of GDP by 2010, and that there were high levels of public debt in Ireland, Spain and France and Greece. In February 2010, eurozone ministers gave assurances that the euro was not in danger and instructed Greece to reduce public expenditure and increase taxation in order to reduce its debt [11].

Developing crisis

(for a more detailed treatment see Eurozone crisis)
During 2010, prospective investors became increasingly reluctant to buy the bonds issued by five eurozone governments (Portugal, Ireland, Italy, Greece and Spain) at the offered interest rates, and the governments concerned had to make a succession of increases in those rates. Two of those governments - Greece and Ireland - eventually decided that, without help, they would not be able to continue to finance their budget deficits, and they sought - and received - loans from other European governments. Those loans failed to reassure potential investors, and in November they demanded further increases in the interest rates on the government bonds of all five governments (including those of Portugal, Spain and Italy, because of fears of contagion from Greece and Ireland).

Prospect

The eurozone crisis has drawn attention to a moral hazard that is inherent in the design of the eurozone. The governments of countries such as Greece are enabled in effect to pledge the resources of the union's more creditworthy members such as Germany against their own borrowings. A no bail-out clause in the Maastricht Treaty was intended to deter abuse, but the time inconsistency of that deterrent was revealed when it was realised that the contagion costs of not bailing out the Greek government would exceed the costs of a bailout.

By December 2010, there was widespread uncertainty about future prospects for the eurozone and beyond. There were doubts about the willingness of European governments to provide further financial support to the five "PIIGS" governments, and speculation that financing difficulties might spread to affect other governments. Some commentators considered it inevitable that one or other of the PIIGS governments would default on, or restructure, its loans, and other commentators forecast departures from the eurozone by governments wishing to escape its restraints. There were even those who envisaged wholesale departures, leading to a collapse of the common currency - an outcome that would impose substantial losses upon countries with investments in euro-denominated securities, and could threaten the stability of the international financial system.

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