Success of the Euro

European Central Bank President Jean Claude-Trichet spoke to a group of students and economists recently on the “overwhelming success of the euro.” Europe as a whole is definitely going through a boom period right now with unemployment in the continent at a 25-year low and steady growth. Much of that success, Trichet claims, should be credited to the unified economic and monetary policy. I want to spend some time this morning talking about that assertion and how the euro has been good (and bad) for Europe.

Now the economic virtues of the European Union are numerous, but I want to just focus on the currency today. One of the advantages of the euro is that weak economies get to piggyback on strong ones. And by strong ones, I mean Germany. For the last 60 or so years, Germany has been the engine that drives European growth, and its currency, the Deutschemark, has been Europe’s most stable. What the euro does is it allows countries like Italy, which had a notoriously bad currency, to benefit from the international confidence in German stability. Germany’s reputation basically grants a halo effect to the rest of Europe. This is essential for the central and eastern European countries because as emerging markets, their currencies might otherwise be subjected to dangerous volatility levels.

Another benefit is the political independence of the European Central Bank. Before European monetary policy became aligned, the central banks of many countries were headed by the finance ministers in those countries. But finance ministers are politically appointed, and so the economic and monetary decisions were often dependent on political gain or loss. The independence of the ECB from European governments has allowed for more stability in monetary policy. This is an especially important front to pay attention to as French President Nicolas Sarkozy continues to push for more input from finance ministers. Let’s hope that ECB can withstand this misguided effort.

While the stable monetary policy has been mostly a good thing for Europe, it does have its share of problems. A unified monetary policy eliminates some independence for individual areas. If most of Europe is going through a bust cycle, the bank will lower interest rates. But if Belgium is experiencing growth, this decision will lead to inflation in Belgium.

One great example of this scenario is Germany after re-unification. The government faced a need to invest in what used to be East Germany, and increased investment led to inflationary pressures. The German government needed to raise interest rates to combat this threat. France faced no such threats, but had to raise interest rates as well to maintain the integrity of the fixed Exchange Rate Mechanism (ERM). The French economy experienced a recession, and plans for a unified monetary policy almost fell apart eight then.

This problem is evident today as well. Most western European economies are stable and developed. Growth is consistent, but not especially fast. Unemployment and inflation are usually at manageable levels. But the newer EU countries, those from Eastern Europe, are at a different stage in their economic growth. They are, as a whole, growing faster as developing countries. Ideally, the different parts of Europe would have different monetary policies to accommodate the different conditions, but the euro would make that impossible. Sharing a currency means sharing a monetary policy. So while the euro is mainly a good thing, it might not be a good thing for everyone involved.