D O N A L O ’ N E I L L A N D JAC K O ’ D O N O H O E

ECONOMICS

INTRODUCTION

• In our presentation we will answer the following questions:• A) Why was euroland deemed to be a non-optimal currency

area?• B) Why did euroland happen despite the fact that so many

thought it was a calculated risk?• C) Describe briefly the following precursors to the euro?

( ERM 1980’s) EMU project/ convergence criteria 1990’s• D) Discuss the following in the context of the advantages of

having a single currency: (why and how a single currency encourages trade and also the advantages of having the ECB as our central bank).

A) WHY WAS EUROLAND DEEMED TO BE A NON-OPTIMAL CURRENCY AREA?

• The Eurozone did not meet a number of the criteria to be considered an optimal currency area. • Firstly, it has poor labour mobility due to the array

of languages and cultures it has. • For example, despite the Spanish economy being

in poor shape, it is very difficult for a Spaniard to move to the likes of Germany (whose economy is far healthier) because they do not speak the language. This is known as the Mundell criterion.

A) WHY WAS EUROLAND DEEMED TO BE A NON-OPTIMAL CURRENCY AREA?

• Secondly, the Eurozone does not have a fiscal transfer system like the United States.

• A fiscal transfer system helps alleviate a recession in one part of the currency area by increasing taxes in an area that is experiencing a boom and transferring them to the recession-hit part.

• For example, the United States has such a system. The fact that Europe does not have this system has made the current crisis worse for the peripheral, recession-hit countries like Spain, Italy, Greece and Ireland.

WHY DID EUROLAND HAPPEN DESPITE THE FACT THAT SO MANY THOUGHT IT WAS A

CALCULATED RISK?

• The Eurozone was very much a political project. Europe has historically been a very divided part of the world and World War 2 is still fresh in the minds of many. The EU was established to try and integrate the countries of Europe by introducing the “four freedoms”.

WHY DID EUROLAND HAPPEN DESPITE THE FACT THAT SO MANY THOUGHT IT WAS A

CALCULATED RISK?

• Economic integration was the next step in this process of convergence and so the euro was introduced. In the eyes of the European countries that became members of the Eurozone, the political reasons were more powerful than the economic reasons and this is why it came about.

C) DESCRIBE BRIEFLY THE FOLLOWING PRECURSORS TO THE EURO:

• - the ERM in the 1980's• The European Exchange Rate system came into effect in 1979 as

part of the European Monetary System. All the countries that signed-up to had their currency pegged to the ECU (European Currency Unit).

• Most of the countries were given a margin of +/-2.25% within which their currencies could fluctuate against the ECU.

• The difficulty with introducing a fixed exchange rate system is that all countries that are part of it need to have more or less the same level of inflation.

• A number of countries struggled with this - particularly the inflation-prone, peripheral countries that were now part of the same currency system as Germany who has very low inflation. It also resulted in Black Wednesday where the Bank of England spent over £3bn trying to stop the pound sterling depreciating too much.

C) DESCRIBE BRIEFLY THE FOLLOWING PRECURSORS TO THE EURO:

• - the EMU project in the 1990s and the convergence criteria

• The Economic and Monetary Union introduced a number of policies to help all member states of the European Union to converge economically.

• The EMU was formally set out in the Maastricht Treaty and laid-out the convergence criteria. The convergence criteria were particularly important for countries intent on joining the euro.

• The convergence criteria consisted of 1) keeping both inflation and interest rates relatively low compared to other members 2) government budget deficits not being allowed exceed 3% of GDP 3) government debt-to-GDP not exceeding 60% 4) keeping their exchange rate stable against other members

D) DISCUSS THE FOLLOWING IN THE CONTEXT OF THE ADVANTAGES OF HAVING A SINGLE CURRENCY:

• - why and how a single currency encourages trade• One key reason behind a single currency promoting

trade is that it does away with certain transaction costs like having to exchange currencies.

• Another reason is that you can be guaranteed you will not lose money when being paid at a later date.

• For example, if an Irish company provides a service in Japan and agrees not to receive payment for a few months in yen, they will lose money if the yen depreciates against the euro in that time frame. This cannot happen between two countries using the euro.

D) DISCUSS THE FOLLOWING IN THE CONTEXT OF THE ADVANTAGES OF HAVING A SINGLE CURRENCY:

• - the advantages of having the ECB as our central bank• The main advantage of having the ECB as our central

bank is that it is modelled on the Bundesbank of Germany, which has a stellar record of keeping inflation low.

• Having the ECB as our central bank has certainly helped reduce the level of inflation in Ireland. This is great for savers, as their deposits cannot be eroded by inflation.

• Arguably, another advantage (in the eyes of the peripheral countries at least) is the ability of the ECB to purchase government debt on the secondary market. This will help calm market jitters and reduce the cost of borrowing for highly indebted European countries

REFERENCES

• Leaving Certificate, Economics, Revised & Updated, Denis L. O’Grady, 2002