Emu And Its Implications On The World

Emu And Its Implications On The World And The Futu Essay, Research Paper

EMU and its Implications on the World and the Future The European economic and monetary union (EMU), and the economic convergence it has inspired, is certainly one of the most important and promising developments in the international monetary system in recent decades. Its formation epitomizes a trend of merging powers to create integrated, liquid, and efficient financial markets. A union with a common currency will lower transaction costs, reduce exchange risk, stimulate competition, and facilitate the broadening and deepening of European financial markets. The EMU’s formation has profound implications for the Euro area, the rest of the world and on the future development of similar economic unions including a system under which the entire world operates with a single currency. This paper seeks to explore the foundations of the EMU, the conditions by which its formation was contingent, EMU’s effect on the rest of the world, and also to hypothesize about a world with a single currency using the EMU model as a possible framework.In Accordance with the treaty signed in Maastricht on February 7, 1992, Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain replaced their national currencies with the Euro on January 1, 1999, based on conversion rates fixed on the previous day. The European Monetary Union was formed in order to enhance budgetary performance and strengthen resilience to inflationary pressure through implementation of a single currency, single exchange rate, and integrated market that will facilitate smooth financial and business transactions. Money and commodities and even factors like labor will move freely, without economic costs, throughout the countries in the union. Hopes of movement toward full employment, increased productivity, better living standards, and cost savings, resulting from the freely flexible markets within the Euro area, also drive the desire for the formation of the EMU.While monetary union carries many benefits, it also poses new challenges to the role of economic policies in safeguarding macroeconomic stability and securing high levels of employment. The responsibility for monetary policy will be transferred to the European Central Bank. The European Central Bank (ECB) and its offices, which will coordinate a single effective monetary policy for the entire area, will unite the EMU members. The ECB is an unprecedented and unique enterprise. Independent countries will be ceding monetary sovereignty to a jointly sponsored entity, without a parallel government body with which the central bank would interact. For this reason, the ECB must be independent and the member countries must hold a confidence in its decisions. In order that member countries may have some influence on monetary policy, a panel of representatives of each of the countries will be able to suggest policies to the ECB but the ECB is in no way obligated to follow or be pressured into decisions. Along with this though comes the responsibility of justifying policy changes to the member countries. As a result of this unique structure of the monetary union, it is necessary that the countries joining the EMU conform to criteria set to achieve a high degree of economic convergence while putting in place the institutional and legal frameworks for conducting a single monetary policy. The Maastricht Treaty of 1992 set the initial criteria for membership in the EMU. The treaty first stressed the importance of prospective member nations to reduce inflation to 3 percent or less in order to converge to a more sovereign position from which the union can approach monetary policy. The countries, with the exception of Greece, which will not join the union until 2001, have achieved levels of inflation well within the ceiling set by the treaty (Chart 1). The treaty also set forth levels for the fiscal area; namely the government deficit of the nation should be below 3 percent of gross domestic product (GDP). Similarly, the EMU members attained a fiscal balance below the ceiling that the treaty set forth (Chart 1). Another area, which the Maastricht Treaty addressed, was the flexibility of markets in order that they may operate freely and lead to efficiency. The treaty points to privatization, the reduction of government involvement in the markets, as one factor leading to flexible markets. It also directs attention to the removal of trade restraints that would limit the efficiency of the markets. Dismantling of monopolies that distort efficient market behavior was also targeted as a goal for the EMU member countries. In summation, the Maastricht Treaty set forth terms for the convergence of prospective EMU members so that the EMU conversion is smooth and helps to create a basis for future success through the policies for more free and flexible markets.The European Central Bank must coordinate a monetary policy for the entire Euro area, but fiscal and structural policies are decentralized in order that individual countries may adapt to their specific needs. In order to resolve possible conflicts in national policies with those of the ECB, the Maastricht Treaty also sets price stability, as the primary objective of the ECB. Price stability, as defined by the ECB’s Governing Council, is “a year-on-year increase in the Harmonised Index of consumer Prices (HICP) for the Euro area of below 2 percent.” This mandate gives clear priority to the maintenance of price stability as the basis of economic conditions that foster sustainable output growth, a high level of job creation and better living standards, all of which are goals of the EMU.In addition to the Maastricht Treaty, the Stability and Growth Pact (SGP) of June 1997 also sets strict guidelines for the coordination of fiscal policy in the Euro area. As its name would suggest, the pact is the agreement that the countries in the EMU will develop policy that fosters stability and growth while maintaining a budgetary position close to balance or in surplus as required by the Maastricht Treaty. It does this by the principle that if countries fail to correct deficits judged to be excessive; they are subject to financial sanctions. One of the major areas addressed by the pact is structural reform of the labor markets. The SGP asserts that the fiscal policies of the member nations should serve to encourage non-inflationary growth by means of job creation. Job creation would increase productivity of the area and thereby increasing the standard of living in the area. Along with job creation, the SGP sets that the fiscal policy of the member nations must reduce the distortions in the tax and social welfare systems. This reform is especially urgent in the structure of social programs that discourage the creation of jobs or weaken the incentive to work, as many of them do. In addition to labor market reform, there must be increased flexibility in prices and wage rates to achieve the levels of employment desired as well as react to economic shocks without the aid of monetary policy. To achieve the needed adjustments through inflation differentials, around the low average inflation rate that the ECB will target, will require greater price and wage flexibility than observed in the Euro area in the past. Without this flexibility, counties that need to strengthen their competitive positions will see increased unemployment as weakness as demand meets rigid wage rates. With flexibility in wage rates, structural unemployment could be reduced as opposed to the people who already have jobs acquiring more wealth. Similarly, reform in the product market area must be directed at making it more flexible as well. Currently, regulations and subsidies weaken competition and distort the market. Without convergence to the terms set forth in both the Maastricht Treaty and the Stability and Growth Pact, the Euro area will face grave problems with the formation of the EMU.Of course, one of the most important conditions for the formation of the EMU is also the most in need of reform in the Euro area. Both the Maastricht Treaty and the SGP mention the importance of labor market reforms in order to obtain a high degree of flexibility. European labor markets have adapted poorly to changes in the global economic environment over the past three decades. Between 1970 and 1997, unemployment in the Euro area has risen by 10 percent of the labor force (Chart 2). The Euro area’s rate of job creation has compared changed even less favorably. Its labor force participation has remained unchanged despite rising female participation. Participation rates in the Euro area are too low. Even a slight increase in rates would yield a significant change in employment and output. In the context of a common monetary and exchange rate policy, inadequate flexibility in labor markets would impair the individual countries to adjust to asymmetric economic shocks. Failure to remove labor market rigidities would result in persistent unemployment and could erode public support over time. Even on a higher level, labor market rigidities could undermine the credibility of the Euro as a stable currency if it is believed that these rigidities make it difficult to pursue prudent macroeconomic policy. Therefore, to ensure the long-term success of the EMU, structural policies must initiate tremendous change in the performance of the European labor market. Structural reform is imperative not only because of the economic waste and social costs associated with it, but also for the reasons aforementioned.Another problem faced with the formation of the EMU is the structure where the European Central Bank has the responsibility of coordinating a single monetary policy for the entire Euro area. The geographic orientation of the monetary policy must necessarily broaden to take into account conditions across the entire area. Policy makers from diverse backgrounds will need to demonstrate that they are able to reach common positions on a pan-European perspective effectively and efficiently. Even so, countries will often find themselves with levels of interest rates that appear too easy or too restrictive. This is a result of the disappearance of national monetary and exchange rate policy, which normally would provide an instrument for the correction of shocks on a national level. Without the possibility of recourse to the exchange rate instrument, flexible markets will become even more important in enabling countries to adjust to shocks, especially asymmetric ones.

The structure of the ECB can also become problematic as a result of its dedication to maintaining low levels of inflation. On the surface this may seem like a good policy, but it provides for the possibility of instability in the exchange rate of the Euro. There could be considerable volatility due to the closed nature of the economy. On a positive note, the European Monetary system has already operated effectively like an exchange rate bloc, another type of closed economy. According to Fabio Ghironi of the University of California, Berkeley, and Francesco Giavazzi of Universit Bocconi and CEPR, volatility could be minimized by the inclusion of as many countries in the EMU as possible. As a result of the ECB deciding on an appropriate monetary policy for the Euro area as a whole, we introduce the possibility of conflicts with economic policy coordination between the member nation’s fiscal policies and the central monetary policy. Fiscal and structural responsibilities are decentralized, unlike the EMU monetary policy, and provide the individual countries with the ability to adapt these policies to fit their specific economic needs. With the monetary conditions resulting from a single monetary policy unlikely to fit well the circumstances of all countries at all times, the strategies for fiscal and structural policies need to ensure that countries are well positioned to deal with country specific problems. By the same token, there is a need for effective coordination to ensure that the combined effect of national policies fits well the overall macroeconomic dynamics of the Euro area. This will complicate the task of achieving an appropriate policy mix at the Euro area level, because inadequate national policies, through their implications for the single monetary policy and exchange rate for the Euro, will inevitably have spillover effects on other countries. This was the reason for the implementation of the Stability and Growth Pact. It is necessary that member nations adhere to the guidelines in the SGP to avoid policy conflicts. In order that the ECB may monitor the progress of its member countries, it has introduced a number of market indicators, or surveillance instruments, that it will utilize in order that fiscal reform may continue in the right direction.Public support is another problematic area for the formation of the EMU. The formation of the EMU may be given the political blame for necessary, but unpopular, measures to reduce government spending, reform social welfare programs, and remove other structural impediments to growth and the success of the EMU. It is necessary that the national authorities make it evident to their citizens that the policy reforms that are being met are good for their own countries and well being, not merely for the good of EMU. For the success of EMU to become plausible, it is necessary that these problems be addressed and minimized.In the long run, assuming that these problems I have presented and others have been resolved, the Euro should become a major power, one that may even rival the dollar, in the international monetary system. The Euro will have its most profound effect on the countries that are part of the EU (European Union) but have chosen not to join the EMU in this the first stage. For Greece, who plans to join the EMU in 2001, the coming period means tight fiscal and monetary policy to ensure that it meets the Maastricht criteria and to maintain exchange rate stability between the drachma and the euro. For Denmark, Sweden, and the United Kingdom, entry into the EMU must be preceded by a public referendum for approval of membership. They too face the challenge of adjusting their existing economic policy framework to be compatible with EMU membership. Norway and Switzerland, which are not members of the EU and therefore ineligible for membership in EMU, will be significantly effected by the new monetary union as a result of their physical proximity and strong trade and financial links with the Euro area (Table 1). For the rest of the world, EMU and economic developments in the Euro area will have smaller direct effects. For example, trade with countries like the United States and Canada make up a relatively small percentage of each countries total trade as seen in the table (Table 1). As a result, there will be relatively small direct effects. However, indirect effects can be more substantial, especially to the United States. The biggest indirect effect to the U.S. is that in the long run, provided that the Euro becomes a stable store of value, a redirection of demand for international reserves from dollars to euros will reduce the U.S. current account deficit. This occurs in response to the outflow of capital from the United States. The euro will rival the dollar and steal some of its importance.Also, increased productivity and cost savings within the EMU could increase competitiveness of Euro area firms and divert trade from non-Euro area suppliers, especially to countries whose currencies are tied to the euro and cannot adjust to reflect relative productivity changes. This increased productivity could also pose a risk for emerging markets. If the EMU is successful, Europe could be more attractive to investors and therefore increase the cost of capital for emerging markets. In summation, the Euro will have great effects that ripple though neighboring countries on across seas to other nations as a result of the influence of its membership.Using the EMU conversion as a model, we can hypothesize that many of the same concerns would be relevant for a single world currency. Countries would probably face some sort of convergence criteria, similar to the Maastricht Treaty and the Stability and Growth Pact, that would facilitate the development of freely flexible markets that would allow for the success of the new “global” currency. The convergence on this level would be much more difficult simply resulting from the number of countries that are tying to meet the criteria. Some countries may be fairly close to satisfying the criteria but for sure many of the other countries would still have significant changes ahead of them which could take a great deal of time. Also it would be more difficult to unite so many countries given the wide range of political systems in the world, some of which would not be accepting of the conversion to a single currency. One of the qualities of a national currency is that there is a certain amount of national pride in that currency. This is why currencies often have very influential figures and national symbols printed on them. But let us assume that the entire world has agreed to convert to a system with a single currency.The structure of the “Global Union” (GU) would probably be very similar to that of the EMU. Like the EMU, there would be a central bank that coordinates monetary policy for the entire world. This also can be problematic because, as with the ECB’s policies for the Euro area may not be specific enough to aid any single countries problems because its policies are intentionally broad, a global central bank would have even greater difficulty with a larger area. Its broadness raises questions about its effectiveness and even its existence. How could a central bank promote stability and growth over such a large area? One difference between the ECB and the central bank of the GU is that the former would never have concerns about exchange rates as the ECB does.It would be absolutely imperative for each country in the union to have a fiscal policy that provides for flexible markets to allow for natural adjustment to economic shocks. Flexible markets, without any government intervention, would settle at their natural equilibria. Under these conditions, the quantity theory of money can be observed as it was in relation to the Gold Standard. Within the union, money and capital will flow freely between the countries based on their general prices. This theory can be explained by the equation MV = PQ where M is the nations money supply, V is the velocity of money, P is the general price index, and Q is physical output. This theory also entails a tendency towards full employment without inflation as a result of instantaneous flexibility of all prices, wages and interests. Any tendency towards unemployment will be corrected by a fall in wage rates. With free and open markets V is a constant, and at full employment Q is constant therefore M is directly proportional to P. This setup would create a truly global market community with no economic barrier between countries, just political barriers.In conclusion, the formation of the European Monetary Union is a tremendous development for the international monetary system. Although formation of the EMU faces many problems, its success would yield a great monetary union that would enhance European financial markets. If the Euro proves to be effective, in time it could lead to greater economic unions across the globe. Ultimately, EMU could be the foundation of a global union with liberal markets together with technology providing a global free market that would make classical economists proud. Bibliography Green, John and Phillip L. Swagel, “The Euro Area and the World Economy,” Finance and Development: December 1998, Volume 53, Number 4, http://www.imf.org/external/pubs/ft/fandd/1998/12/green.htm>, December, 1998. International Monetary Fund, “Conference Focuses on Implications of EMU for Europe and the World Economy,” IMF Survey: April 7, 1997, Volume 26, Number 7, International Monetary Fund: 1997. International Monetary Fund, “Economic Policy Challenges Facing the Euro Area and the External Implications of EMU,” World Economic Outlook: October 1998, Chapter V, International Monetary Fund: 1998. Issing, Otmar “The Monetary Policy of the Eurosystem,” Finance and Development: March 1999, Volume 36, Number 1, http://www.imf.org/external/pubs/ft/fandd/1999/03/issing.htm>, March 1999. Knot, Klaas, Donogh McDonald, and Karen Swiderski, “Policy Changes for the Euro Area,” Finance and Development: December 1998, Volume 35, Number 4, http://www/imf/org/external/ft/fandd/1998/12/knot.htm>, December 1998.