A harvest failure, strikes, or war, in one of the countries causes a loss of real income, but the use of a common currency (or foreign exchange reserves) allows the country to run down its currency holdings and cushion the impact of the loss, drawing on the resources of the other country until the cost of the adjustment has been efficiently spread over the future.
If, on the other hand, the two countries use separate monies with flexible exchange rates, the whole loss has to be borne alone; the common currency cannot serve as a shock absorber for the nation as a whole except insofar as the dumping of inconvertible currencies on foreign markets attracts a speculative capital inflow in favour of the depreciating currency. ‘ (Mundell, 1973, p. 115) Through risk sharing there would be lower interest rates. For any given interest rate that is higher, investment projects will tend to be riskier in order to justify the high rate of interest. This in turn pushes interest rates up.
By sharing this risk across a currency union, lower interest rates reduce the amount of risky projects that are selected by the market. De Grauwe argues that a lower interest rate and the expectation of lower interest rates will encourage growth in the short term. When uncertainty decreases, R1 moves to R2 and the economy will temporarily grow faster until it reaches point B, at which point it will return to the Long-term growth rate. The Euro as a World Currency From the outset the ECB has been very anti-inflationary. This has safeguarded the value of the Euro on international markets.
The future looks good for the Euro as a world currency. The recent falls in the value of the dollar may lead many speculators to switch to the Euro as a more reliable store of value. If Britain were part of EMU this could mean investing in Britain. Currently many in Europe are worried by the value of the Euro against the dollar. This is primarily because world trade is largely conducted in dollars. If that were to change to Euros, Britain would gain from being a part of EMU. Negotiating as the EU, the individual countries of Europe have been able to stand up to the USA on trade issues.
EMU could work in the same way to protect our interests. In the past, the countries of Europe have at times been forced to prop up the dollar in order to protect their export markets, not only to the United States but also to the rest of the world, as the dollar was the currency of choice for most international dealings. ‘In 1987 two thirds of the US current account deficit was financed not by the private markets but by foreign central banks who were afraid of the competitive effects of their currencies appreciating against the dollar’ (Transatlantic Perspectives on the Euro, p.
24) With the euro, Europe no longer has to concern itself as much with the value of the dollar. Obviously trade with the USA will be affected by a weak dollar, as is the case today. However, that accounts for less than 15% of trade for most EU countries. If the euro maintains its strength and reputation it could lead to many advantages. Europe will gain in terms of seigniorage. Seigniorage is the revenue that a government receives from the use of their currency.
‘If the Euro were to close one half of the gap between it and the dollar as a currency of denomination of private international financial assets, roughly $400 billion in investments would be re-allocated from dollar to Euro assets’ (Transatlantic Perspectives on the Euro, p. 24). However, the European capital markets may take longer to take full advantage of the single currency. ‘Stock market capitalisation of the euro – 12 countries was roughly 1/3 of the US in 1995. Adding the UK would raise it to 1/2. ‘ (Transatlantic Perspectives on the Euro, p. 25)
Even without stock market capitalisation, if the Euro is a strong currency, foreign investors will wish to invest in Euros in some way or another. European banks will attract investment. The size of this effect, however, is uncertain. London is the financial centre of the world without having a major domestic currency. But the Euro could provide a useful boost to Foreign Direct Investment. EMU will increase our levels of international trade Increasing trade is one of the primary objectives of the EU. Trade increases output through increased specialisation and a more efficient allocation of resources.
Trade increases our consumption possibilities. All countries gain regardless of income level or economic structure. As long as they are different in technology (Ricardian model) or in factor endowments (Heckscher-Ohlin model), potential gains from trade always exist. Therefore if a common currency induces large increases in trade it is an important benefit of EMU. Rose (2000) considered the effect that a common currency area has on trade. He was the first to do so. He explains that there are potentially massive gains from a currency union. He uses the gravity model to calculate the effects.
Rose makes a valid point that trade within a domestic economy far exceeds that of trade across international borders, and that the more we move towards making the EU a domestic market, the more trade across the European borders will increase significantly. ‘The evidence of international bias is clear; trade within countries is simply huge compared to trade between countries, even for well-integrated areas like the EU. Countries have a number of important aspects for commercial trade, including a common currency, common cultural norms, common legal system, common history, common norms, and so forth.
A common currency is a piece of this package; and it seems to be an important piece’ (Rose 2000 p. 32). ‘Countries that use the same currency tend to trade disproportionately. My point estimate is that countries with the same currency trade over 3 times as much with each other as countries with different currencies’ (Rose 2000 p. 17). Rose uses the example of trade across Canada and with the US to illustrate this point. ‘Trade between two Canadian provinces is more than 20 times larger than trade between a comparable Canadian province/American state pair.
Part of this home bias effect may stem from the fact that a single currency is used inside a country’ (Rose 2000 p. 11) He explains that the benefits of a currency union have previously been underestimated because people have assumed that the effects of a fixed exchange rate would be the same as the effects of a currency union. Rose finds that there is a big difference. ‘Most of the extant literature presumes that a common currency is equivalent to reducing exchange rate volatility to zero (Frankel and Rose). Yet my estimates easily distinguish a currency union and zero exchange rate volatility…
The effect of a common currency is much larger than the hypothetical effect of reducing exchange rate volatility to zero’ (Rose 200 p. 17). The seemingly small costs of exchanging currencies seem to deter people quite a lot. Johnny Akerholm uses Rose’s discussion to point out that trade is typically based on long-term relationships. ‘If a firm wants to penetrate a foreign market, investment in trade channels and marketing is required over several years. A common currency reduces the risk and enhances the market, in particular for small and medium sized firms’ (Rose 2000 p.
39) o conclude, there are many benefits associated with EMU. The principle benefit is the free flow of trade, which has been quantified by Rose and appears to have massive potential for growth. Many of the gains we haven’t mentioned are political rather than economic. Therefore even if the gains don’t prove to be that large, as long as the costs don’t outweigh the benefits, Britain should join EMU. In the next chapter we look at the Theory of Optimum Currency Areas and analyse the potential pit falls of a Monetary Union.