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The euro has been in existence just long enough to generate sufficient data for a first look at its actual performance, having been introduced in January 1999. This assessment presents eight studies that use post-1999 data to provide a first look at how the euro is actually affecting trade, financial markets, macroeconomic policy-making, and Europe¡¯s economic performance.
1.1 What is the Euro?
The Euro is the single currency used in 12 EU member states. The euro came into being in cashless form on 1 January 1999 when these member states formed an Economic and Monetary Union (EMU) and permanently locked the exchange rates of their currencies against the Euro. Euro notes and coins were put into circulation in these 12 EU states on 1 January 2002 .
1.2 Countries in the euro area
The 12 countries in the euro area are: Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain and Greece. The United Kingdom (UK) has decided not to participate but has indicated that it may consider joining at a later date.
Euro notes and coins were put into circulation on 1 January 2002. The euro is part of the process of EMU. EMU is provided for in the Maastricht Treaty, which the people of Ireland endorsed by referendum in June 1992. As well as the Euro, EMU has involved the creation of an independent European Central Bank (ECB).
The euro is used also in Andorra, Monaco, San Marino and Vatican City. Several overseas territories of the 12 "Euro zone" countries use the euro: these include the Canaries, Madeira, the Azores and the French Outre-Mer territories (Guyana, Martinique, Guadeloupe, Reunion and the collective territories of Mayotte and St Pierre and Miquelon) .
2 Development of Euro
1 July 1990 Stage one of economic and monetary union begins. Capital movements in the EU Member States are fully liberalized (except where temporary derogations have been granted).
1 January 1993 The single market is completed.
1 November 1993 • The composition of the ecru basket is frozen.
• The Treaty on European Union signed in Maastricht enters into force.
1 January 1994 • The European Monetary Institute (EMI) is set up in Frankfurt.
• Procedures for coordinating economic policies at European level are strengthened.
• Member States strive to combat 'excessive deficits' and to achieve economic convergence.
31 May 1995 The Commission adopts Green Paper on the single currency (reference scenario for the transition to the single currency).
15 and 16 December 1995 • Madrid European Council
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• Technical scenario for introduction of the euro and timetable for changeover to the single currency in 1999 finalized (end of the process scheduled for 2002).
16-17 June 1997 Amsterdam European
Council • Madrid European Council
• The name 'euro' adopted for the single currency.
• Technical scenario for introduction of the euro and timetable for changeover to the single currency in 1999 finalized (end of the process scheduled for 2002).
1 June 1998 Creation of the European Central Bank
31 December 1998 Conversion rates fixed
1 January 1999 Stage three of EMU begins.
• The euro becomes the new currency for eleven Member States and a single monetary policy was introduced under the authority of the ECB, heralding the third and final stage of monetary union.
• Euro area financial markets are switched to the euro, including foreign exchange, share and bond markets. New euro area government debt is exclusively issued in euro as from this day.
1 January 2001 Greece becomes the twelfth EU Member State to adopt the euro.
1 January 2002 The euro is launched.
1 March 2002 The euro becomes the sole legal tender in all euro area countries.
28 June 2004 Among the 10 Member States that joined the EU in May 2004, Estonia, Lithuania and Slovenia enter ERM II.
2 May 2005 Latvia, Cyprus and Malta join ERM II.
3 TRADE EFFECTS OF THE EURO
The classic currency union trade-off highlighted by Robert Mundell in 1960 weighs a trade gain against a stabilization loss. While the existence of both the trade gain and the stabilization loss has always seemed intuitively plausible to most observers, measurement of the trade effect probed elusive. Indeed until Andy Rose published his path breaking paper in the April 2000 issue of Economic Policy, the received wisdom was that the trade effect of exchange rate volatility was negligible. What Rose found was that the pro-trade effect of a currency union was huge, with a common currency boosting trade between nations by as much as 300%. Subsequent studies confirmed the existence of the effect, but found it to be smaller. For example, using a different statistical technique, an article published in the October 2001 issue of Economic Policy by Torsten Persson finds the effect to be something like 10-20%.
The applicability of these findings to the euro has always been questioned since. Rose¡¯s results stemmed from data on currency unions involving very poor and very, very small nations. Fortunately, the time for extrapolating from evidence on other currency unions is at an end. Alegandro Micco, Ernesto Stein and Guillermo Ordonez use data on the actual trade performance of enroland nations to check whether the euro has boosted trade. They find that the euro has already had a noticeable impact on trade of euroland nations by between 4 and 16%.The findings of Micco at al, however, raise many questions as the discussion by Karen Helene Midelfart points out. The extensive sensitivity analysis performed by the authors makes it clear that euroland membership is not a magic formula for trade-the trade effect is quite different for the various euro nations- ranging from a negative impact for Greece to a very big positive impact for the Netherlands. Moreover, the authors find that adoption of the euro tends to boost a nation¡¯s trade with all nations, not just other euroland members. This suggests that adoption of the euro promotes trade in a way is more akin to a unilateral trade opening than it is to formation of a customs union.
While much additional research needs to be done before the profession can confidently assert that it knows how and how much the euro boosts trade, the Micco et al paper does establish that the euro has already boosted trade.
4 TheWelfare Effects of Common Currencies
In this section, I investigate various theoretical arguments pertaining to the welfare effects of a
monetary union. The more ¡°mechanical¡± effects of common currencies (e.g., transactions-cost
savings on currency conversion, the loss of foreign exchange trade, or the liquidity effect reducing
the transactions costs of buying and selling financial assets) are specific to each currency-union
project, and they are described in more detail in section 3, which outlines the first experience of
European financial markets under EMU.
Here, I focus on the two main principles regarding the long-run macroeconomic implications of
monetary union operating through financial markets. The underlying assumption is that multiple
currencies prevent national financial markets from integrating more deeply, thus depriving agents
of the potential benefits of financial market integration.
First, I examine the benefits of risk-sharing through asset markets, whereby risk-averse agents can
insure against income shocks by diversifying their portfolio across the whole unified currency
area, rather than being restricted to the (smaller) national asset markets.1 Second, I examine the
theory and empirical evidence of the allegedly positive link between financial market integration
and growth, and give some estimates of the potential growth effects of EMU.
5 International risk-sharing
The theory of interregional and international risk-sharing
It is a well-known result of general-equilibrium theory that if asset markets are complete, riskaverse
individuals can and will fully insure against consumption fluctuations across states. In an
environment that has neutral money and multiple currencies, this implies that the choice of an
exchange rate regime will not have any impact on social welfare (Helpman 1981, Kareken and
Wallace 1982, Lucas 1982).
In practice, however, asset markets will be incomplete and risk cannot be completely hedged, in
particular at the more aggregate level, and so the exchange rate regime may indeed matter. There are two approaches to considering the impact of the exchange rate in the context of region-specific
shocks hitting the economy.
First, flexible exchange rates may substitute for other adjustment mechanisms (like price and
wage adjustments or central fiscal transfers) if the latter are not available. This important insight,
by Mundell (1961), underlies most of what has become known as the Theory of Optimum
What is perhaps less known is that, several years later, Mundell presented a new view of common
currencies as a means of smoothing shocks by better reserve pooling and portfolio diversification.
According to this approach, which has recently been ¡°rediscovered¡± by McKinnon (2000),
countries sharing a single currency can mitigate the effects of asymmetric shocks among
themselves by diversifying their income source and adjusting their wealth portfolio.
The international diversification of income source can operate through income insurance when
residents of a country hold claims to dividends, interests, and rental revenue in other countries.
Such ex-ante insurance allows the smoothing of both temporary and permanent shocks as long as
output is imperfectly correlated.
A country¡¯s residents can adjust their wealth portfolio in response to income fluctuations by
buying and selling assets and borrowing and lending on international credit markets. Such ex-post
adjustment allows the smoothing of transitory shocks (Mongelli 2002, 13, and references therein).
By emphasizing the foreign exchange market¡¯s forward-looking nature, Mundell (1973) shows
how future exchange rate uncertainty could disrupt the capital market by inhibiting international
portfolio diversification and risk-sharing.2 As McKinnon (1996) demonstrates, the gains from
proper risk-sharing through a common currency should show up as a net reduction in risk premia
on interest rates for the system as a whole.
This is the primary objective pursued by the European System of Central Banks (ESCB), which operates in full independence.
Sound public finances:
The Treaty sets out a number of requirements in order to avoid that Member States run excessive levels of government deficits or excessive levels of government debt relative to GDP.
The Stability and Growth Pact moreover prescribes that Member States should have budget balances close to balance or in surplus over the medium term.
Low interest rates:
The level of interest rates benefits from low inflation expectations, improved control of government debt (which allows for improved borrowing possibilities for private companies) and the increased size of euro securities markets, which improves liquidity.
In addition, the elimination of exchange rate fluctuations has a positive impact on intra-European trade and a further downward impact on the level of interest rates.
Incentives for growth, investment and employment:
Price stability, sound public finances and low interest rates constitute ideal conditions to foster economic growth, investment and employment creation within the euro area.
The euro introduction is undoubtedly beneficial for the country, but same of negative impacts are necessary. The fulfillment of the economic convergence criteria already beginning of 2007 is realistic, but the national authorities must carefully monitor macroeconomic developments and pursue prudent economic policies.
This paper has reviewed both the theoretical and empirical literature on the impact of euro to Europe on financial markets. Euro currency can improve welfare. Agents will be encouraged to diversify their portfolios internationally, thus obtaining decentralized insurance against asymmetric shocks to their income. The evidence shows that idiosyncratic shocks are larger, and smoothing is lower, internationally relative to nationally, and that a large share of international risk-sharing is due to diversified property holdings in the European case. The experiences that European financial markets have had introducing the euro shows that monetary union can indeed provide an important stimulus towards financial integration, bothdirectly and indirectly.