The Eurozone and the Single Currency: Told You So?

Monetary policy refers to attempts by governments or their agents (such as the Bank of England or the European Central Bank) to influence the level of economic activity through manipulating interest rates to influence the supply and the price of money. In so doing, they hope to influence the levels of consumer spending and investment to affect aggregate demand and thus maintain target levels of inflation, which in the UK and the eurozone is 2.0%.

When the 12 member states that currently comprise the eurozone gave up their currencies in favour of the euro, the ECB took on the responsibility of monitoring monetary policy for the euro area.

To join the euro, member states had to demonstrate a range of convergence criteria designed to ensure that they were financially stable enough to cope with the shock of entering the euro (that government spending was under control, that borrowing was a manageable proportion of GDP and so on) and that each country was at a stage in the economic cycle where the common monetary policy would not cause massive disruption to its macro-economic position.

This is one reason why the UK did not deem it appropriate to join the euro at the outset. It seemed to be at a different stage in the economic cycle to many in the rest of Europe - it was experiencing a period of relative growth whereas the rest of Europe was suffering from varying degrees of economic slowdown. If the UK had joined at this time and the euro-wide interest rate had been set at a low level to reflect the average position of the rest of Europe, then the UK would have experienced strong inflationary pressures as a result of a growing economy and a low interest rate.

Despite the stringent rules on joining the euro, there were a number of commentators who suggested that not all of the countries seemed to comply with all the regulations. In any event, most countries had their own problems as a result of structural changes over many years. Germany, for example, had one of the biggest following the unification of the former communist East Germany with the West in 1991. The unification may have been politically and emotionally desirable but it placed massive economic strains on the German economy and is still doing so. Economies do not change overnight nor do they respond to policy initiatives overnight - structural changes take many years to work their way through.

The problem facing the ECB, therefore, is in setting interest rates that meet the differing needs of each country, thus keeping the move to convergence and managing the EU economy as if it was 'one country'.

Image: The euro - coming under pressure? Copyright: Davide Guglielmo, stock.xchng

These problems are exemplified in the following:

Assume that the level of unemployment in Germany stood at 10% and that inflation was 1.2% and economic growth 1.1%, whereas the level of growth in Spain was 2.7%, unemployment at 5% and inflation at 3%.

These figures would imply that Germany was at a downward phase of the economic cycle with classic symptoms of low growth - high unemployment and low inflation. Spain, meanwhile, would more likely be at a stage of the economic cycle that is on the upward path.

The monetary policy necessary in Germany would be an expansionary one - interest rates would need to be reduced to stimulate consumer spending, investment and thus aggregate demand. In Spain, however, the opposite policy might be necessary. The strong growth, relatively low unemployment and 'high' inflation would suggest that monetary policy should be tightened; interest rates increased to choke off the growth in consumer spending and reduce the pressure on inflation bringing economic growth to a level where it is more sustainable.

If the ECB has to set rates for both these countries it faces real difficulties. If it sets rates too high, the German economy could further decline and the possibility of recession is very high. If it sets rates too low - favouring the German economy - Spain's economy runs the risk of growing too quickly and inflation levels rise above any target level the ECB has.

Look at the diagram below showing a fairly traditional explanation of the business cycle. Potential growth shows the likely trend of growth in the economy over a period of time and the actual growth shows what the growth rate is at any point in this period. The business cycle might present a picture that suggests some sort of 'rollercoaster'. Take Spain, for example. We have put Spain on the upward part of the business cycle - what conclusions can we draw from this? We could suggest that in the future Spain is likely to experience further growth and that it is likely to face some bottlenecks in the economy as aggregate demand (AD) rises at a faster rate than aggregate supply (AS). As the actual growth rate gets closer to the potential growth rate, inflation is likely to result as supply shortages in labour and resources put pressure on production.

Germany and Italy have been put at the lower end of the dip in the business cycle (point 1). But, should we put these countries in a position where the diagram would suggest that the next step is further economic slowdown or would their position be at point 2 where the diagram suggests the next phase would be as part of the upswing?

Looking at business cycles in this 'evolutionary' and inevitable way is to mis-represent the phenomena of the business cycle model. The 2004 Nobel Prize winners, Finn Kydland and Edward Prescott, argued that this is exactly what has been happening in economics for many years and that the assumptions we have about the position of economies on the business cycle and the appropriate policies to deal with those problems might be misguided. In an upswing, for example, traditional theory would suggest prices will start to rise - so-called procyclicality. (Equally in a downturn we would expect price increases to be smaller or even falling depending on the depth of the downturn.) Kydland and Prescott suggested that this may not be the case and that an upswing can be associated with reduced price pressures.

Such an argument throws the traditional business cycle analysis on its head and gives us quite a different picture of the use and effect of monetary policy on the eurozone - and indeed every other economy - than perhaps we might have thought.

There is still a problem, however, facing the ECB in setting an interest rate which meets the needs of all 12 member states of the Eurozone and eventually, one presumes, setting a rate that will satisfy all 25 member states! This is why the opponents of the single currency are so concerned about UK entry. The loss of sovereignty they refer to is the inability of the UK to be able to set monetary policy to reflect the economic conditions in the UK; if the UK has to cope with a European wide interest rate it risks facing economic problems which it is unable to do anything about. The Government of John Major faced such a situation to a certain extent in 1992 when the UK was part of the Exchange Rate Mechanism. The UK was experiencing a serious economic recession but could not reduce interest rates as it would have liked because that would have put pressure on the pound to fall below its agreed level in the mechanism.

The theory certainly seems to suggest that the problems of a single currency could be very difficult to solve and the experience of the first few years of the euro seems to provide some evidence of these practical problems. However, the matter is not always quite as simple as it seems!

Data / Facts / Figures

Key economic indicators in selected European countries, March 2005

Source: Economic and financial indicators overview, The Economist, 5th March 2005

Tasks

Use the data in the table on economic indicators to discuss the issues facing the ECB in setting interest rates in the eurozone. Does the evidence provided in 'The News' section above suggest that a single European monetary policy is unworkable?

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Mark Scheme

The questions can form the basis for a class discussion or can be used as a written exercise. They are very open ended and there is a great deal of scope for you to develop your answers/discussion. Some of the things you will need to consider will be as follows:

The answer seems to be straightforward on the face of it - the difficulties faced by countries in the eurozone mean a single interest rate does not work. But, that assumes that the theory behind economic cycles is sound. Try drawing a simple 'business cycle' diagram with the countries of the EU on it to see just how difficult it is to match an interest rate to their respective economic positions. All this assumes that business cycles are showing you an appropriate means for comparing different countries and that each country is the same.

Look at the data and you begin to see some anomalies. Not all countries are facing the same situation. Belgium, for example, has strong economic growth and quite high inflation, but its unemployment rate is also very high. Look at the other countries - are the figures what you might expect to find in terms of their position on the business cycle?

What other information would you need to know to be able to form a more accurate analysis of the situation? There are links to other statistics that will be relevant to your discussion and there will be plenty more - look at some of the country profiles, for example, using either the Economist or the FT. Ask yourself what determines unemployment and whether the cause of unemployment in the eurozone is really to do with the euro and the ECB's interest rate policy or whether it might be something else - structural change, for example (note the reference to Germany's plight following unification).

What the questions are trying to do is to encourage you to think through the issues involved rather than just accepting the evidence at face value - you are being asked to critically analyse the issue. At the end of the exercise you may come to the same conclusion but you might start to appreciate that things are not always as straight forward as they appear to be and that you might need to qualify your arguments a little more!

Mind your Business - 13 March 2005