The Euro in the 21st Century (The International Political Economy of New Regionalisms)

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The Euro in the 21st century

The International Political Economy of New Regionalisms Series The International Political Economy of New Regionalisms series presents innovative analyses of a range of novel regional relations and institutions. Going beyond established, formal, interstate economic organizations, this essential series provides informed interdisciplinary and international research and debate about myriad heterogeneous intermediate level interactions. Reflective of its cosmopolitan and creative orientation, this series is developed by an international editorial team of established and emerging scholars in both the South and North. It reinforces ongoing networks of analysts in both academia and think-tanks as well as international agencies concerned with micro-, meso- and macro-level regionalisms. Editorial Board Timothy M. Shaw, Institute of International Relations at The University of the West Indies, St Augustine, Trinidad and Tobago Isidro Morales, Tecnológico de Monterrey, Escuela de Graduados en Administracion (EGAP), Mexico Maria Nzomo, Institute of Diplomacy and International Studies, University of Nairobi Nicola Phillips, University of Manchester, UK Johan Saravanamuttu, Institute of Southeast Asian Studies, Singapore Fredrik Söderbaum, School of Global Studies, University of Gothenburg, Sweden and UNU-CRIS, Belgium Recent titles in the series (continued at the back of the book) Crafting an African Security Architecture Addressing Regional Peace and Conflict in the 21st Century Edited by Hany Besada Comparative Regional Integration Europe and Beyond Edited by Finn Laursen The Rise of China and the Capitalist World Order Edited by Li Xing

The Euro in the 21st Century Economic Crisis and Financial Uproar

María Lorca-Susino University of Miami, USA

© María Lorca-Susino 2010 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise without the prior permission of the publisher. María Lorca-Susino has asserted her right under the Copyright, Designs and Patents Act, 1988, to be identified as the author of this work. Published by Ashgate Publishing Limited Ashgate Publishing Company Wey Court East Suite 420 Union Road 101 Cherry Street Farnham Burlington Surrey, GU9 7PT VT 05401-4405 England USA www.ashgate.com British Library Cataloguing in Publication Data Lorca-Susino, María. The euro in the 21st century : economic crisis and financial uproar. -- (The international political economy of new regionalisms series) 1. Euro. 2. Euro area. 3. European Union countries-Economic integration. 4. European Union countries-Economic conditions--21st century. 5. Financial crises-European Union countries. 6. Board of Governors of the Federal Reserve System (U.S.) 7. European Central Bank. 8. International Monetary Fund. I. Title II. Series 332.4'94-dc22 Library of Congress Cataloging-in-Publication Data Lorca-Susino, María. The euro in the 21st century : economic crisis and financial uproar / by María Lorca-Susino. p. cm. -- (The international political economy of new regionalisms series) Includes indexes. ISBN 978-1-4094-0418-7 (hbk) ISBN 978-1-4094-0419-4 (ebk) 1. Euro. 2. Euro area. 3. European Union countries--Economic conditions--21st century. 4. Europe--Economic integration. I. Title. HG925.L67 2010 337.1'42--dc22

 ISBN 978 1 4094 0418 7 (hbk) ISBN 978 1 4094 0419 4 (ebk) I

2010026844

Contents List of Graphs   List of Tables   Foreword   Acknowledgements   List of Abbreviations   PART I

HISTORICAL AND THEORETICAL INTRODUCTION TO THE EURO

1 Historical and Theoretical Considerations   PART II 2

vii xi xiii xvii xix

3

THE EURO AS A COMMON, INTERNATIONAL, AND GLOBAL CURRENCY: AN EMPIRICAL STUDY

The Euro as a Common Currency  

27

3 Statistical Analysis of the Euro as a Stabilizer for the Eurozone  

49

4

81

The Euro as an International and Global Currency  

PART III

THE EURO AND THE EUROZONE: BEFORE, DURING, AND AFTER THE FIRST ECONOMIC CRISIS OF THE 21st CENTURY

5

The New Monetary Order of the 21st Century  

111

6

The Eurozone and its First Economic Crisis  

143

7

The Future of the Eurozone and the EU at a Crossroads: Coordination or Breakup  

183

8

The Euro in the Twenty-First Century: The Need for a “Euro Index”  

211

The Euro in the 21st Century

vi

PART IV 9

CONCLUSION

The Eurozone in the 21st Century  

249

Bibliography  

275

Index  

309

List of Graphs 2.1 European Commission Euro Area Business Climate Indicator   2.2 US Conference Board, US Leading Index of 10 Ten Economic Indicators   2.3 GDP based on purchasing power parity (PPP) per capita in selected AEC countries   2.4 Inflation in selected AEC countries   2.5 GDP based on purchasing power parity (PPP) in Mercosur full member countries   2.6 Inflation in Mercosur full member countries   2.7 Current account balances in Mercosur full member countries   2.8 Alternative measures of political and economic integration—six countries compared   2.9 Economic freedom—six countries compared   2.10 Some problematic factors for political integration—six countries compared   3.1 US Dollar Index (USDX)   3.2 US Dollar Index with 20-month simple moving average and de-trended   3.3 Deutsche mark composite   3.4 Deutsche mark composite and US Dollar Index   3.5 Evolution of the euro   3.6 Euro and US Dollar Index   3.7 Deutsche mark composite and euro   3.8 French franc and euro   3.9 Spanish peseta and euro   3.10 Italian lira and euro   3.11 UK pound and euro   3.12 Euro and UK pound since 1981   3.13 Dow Jones Industrial Average (DJIA)   3.14 DJIA with 30-month moving average and de-trended   3.15 Deutscher Aktien IndeX 30 (DAX)   3.16 DAX with 30-month moving average and de-trended   3.17 DJIA and US Dollar Index   3.18 DAX and euro   3.19 DAX and euro   3.20 DJIA and DAX with covariance   3.21 DJIA, DAX, and Eurotop 100  

32 33 37 37 40 41 41 42 43 45 56 57 57 58 59 59 60 60 61 61 62 63 64 64 65 66 66 66 67 67 68

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3.22 Crude Oil and CRB Indexes   69 3.23 CRB and Crude Oil Indexes with covariance   69 3.24 CRB Index and US Dollar Index   70 3.25 Crude Oil and US Dollar Indexes   70 3.26 Crude Oil and US Dollar Indexes with covariance   71 3.27 Crude Oil Index and euro   72 3.28 US 2-year Treasury Note and Eurodollar (3 months)   73 3.29 US 10-year Treasury Note and Bund   74 3.30 Eurodollar (1 month) and Eurodollar (3 months)   74 3.31 EURIBOR (3 months) and Eurodollar (3 months)   75 3.32 EURIBOR (3 months) and LIBOR (1 month)   76 3.33 EURIBOR (3 months) and euro   77 3.34 Euro and Bund   77 4.1 Export activity between Eurozone’s Member States   84 4.2 Total bond issuing activity in Eurozone   86 4.3 Evolution of Eurozone bond issuing—central and local governments 87 4.4 Sovereign bond spread with German yield   89 4.5 Evolution of Eurozone bond issuing—corporate and financials   90 4.6 GDP comparisons—US, EU, and Eurozone   94 4.7 Comparison of growth in trade exports to the world   95 4.8 Size of the capital market, 2007   97 4.9 Bond, equities, and bank assets compared (as % of GDP), 2007   98 4.10 Financial asset comparison—US and Eurozone   99 4.11 Hourly compensation costs in manufacturing   100 4.12 Labor productivity growth indexes compared   101 4.13 Capacity utilization comparison   102 4.14 Comparison of US and Eurozone GDPs   104 4.15 Consumer Confidence Indicators—Eurozone and US compared   105 4.16 Global capital flows   106 5.1 Euro and UK pound, 1981 to 2010   123 5.2 Euro and UK pound, April 2008 to August 2009   125 5.3 Currency reserves worldwide   129 5.4 Special drawing rights, percentage change   130 5.5 Time series data on international reserves and foreign currency liquidity—selected countries   134 5.6 Bank of Russia foreign exchange reserves by currency   136 5.7 Banco Central do Brasil—reserve currency composition   137 5.8 Chinese yuan and Hong Kong dollar   140 5.9 Euro and the euro/Hong Kong dollar composite   140 5.10 Euro/yuan and euro   140 6.1 Comparative analysis of government debt levels, 2010   145 6.2 Euroarea government debt as % of GDP   146 6.3 Government debt in Eastern EU countries   147 6.4 General government financial balances—selected countries   149

List of Graphs

ix

6.5 Eurozone government deficits   150 6.6 Deficits and surpluses in Eastern EU countries   151 6.7 Sovereign bond spread with German yield   152 6.8 The Markit iTraxx Europe Index   154 6.9 EU current account   155 6.10 Current account balances   155 6.11 Economic Sentiment Indicator (ESI)   157 6.12 Recent Spanish economic history   165 6.13 Euro and Crude Oil Index   168 6.14 Spanish peseta and Crude Oil Index   169 6.15 Spanish peseta and DJIA   170 6.16 Credit default swaps   171 6.17 Spanish Tourism Index   173 6.18 Average labor costs per worker in Spain   174 6.19 Spain’s trade balances, 1997–2008   176 6.20 Academic excellence—comparison of Spain with selected countries 177 6.21 Labor productivity index—selected countries   178 6.22 General government debt as % of GDP—Euroarea and Spain   179 6.23 Spain’s total government revenues and expenditures   180 7.1 Trade balances for Germany and the Eurozone   194 8.1 US Dollar Index   214 8.2 Trade-weighted US Dollar Index   216 8.3 US Dollar Index and trade-weighted US Dollar Index   217 8.4 Random walk   219 8.5 White noise   219 8.6 DJIA, DAX, and Eurotop 100   222 8.7 Australian dollar and DJIA   223 8.8 New Zealand dollar and DJIA   223 8.9 Singapore euro and US Dollar Index   224 8.10 US Dollar Index movement—June 2004 to March 2010   225 8.11 A periodic trajectory 228 8.12 Critical point, convergence, and attractor   228 8.13 Sandpile   229 8.14 Critical point in thermodynamics   230 8.15 Fractals: year, month, week, day   231 8.16 Cross-rates used for the Australian Index   234 8.17 Cross-rates for the Australian Index at the critical point   235 8.18 Australian Index and its cross-rates   236 8.19 Cross-rates used for the New Zealand Index   237 8.20 Cross-rates for the New Zealand Index at the critical point   238 8.21 New Zealand Index and its cross-rates   239 8.22 Cross-rates used for the Euro Index   240 8.23 Euro Index and its cross-rates   241 8.24 Self-made US Dollar Index and its cross-rates at the critical point  243



The Euro in the 21st Century

8.25 Indexes compared   9.1 Job openings and labor turnover survey   9.2 Comparison of US and EU productivity   9.3 Comparison of US and EU capacity utilization   9.4 US Small Business Optimism Index   9.5 European Commission Euro Area Business Climate Indicator   9.6 Comparison of Consumer Confidence Indicators—US Conference Board and European Commission Consumer Indicator for the Eurozone   9.7 Gross household saving rate—share of gross savings as % of gross disposable income  

244 252 252 253 254 255 257 258

List of Tables 1.1 Monetary system date overview   1.2 Summary of monetary evolution from the Bretton Woods System to the European Monetary System   2.1 List of existing and de facto monetary unions   2.2 List of planned monetary unions   2.3 Recognized regional economic communities (RECs)   3.1 Summary of indexes   3.2 Summary of currencies analyzed   3.3 Summary of stock exchange, Crude Oil, and CRB Indexes   3.4 Summary of money market indexes   3.5 Summary of statistical study   3.6 Custom-made covariance formula   3.7 Custom-made de-trended formula   3.8 20-month simple moving average   4.1 Functions of an international currency   4.2 Some currencies pegged to the US dollar, the euro, the UK pound, and other currencies   4.3 Credit rating of countries by Moody’s, Standard and Poor’s and Fitch, as at March 7, 2010   4.4 Currency Composition of Official Foreign Exchange Reserves (COFER) (in US$ millions)   4.5 Leading exporters and importers in world merchandise trade, 2008 (in € billions)   4.6 Financial assets, US and Eurozone compared (in US$ trillions, using 2008 exchange rates for all years)   5.1 Currency distribution of reported foreign exchange market turnover: percentage share of average daily turnover, April 2007   5.2 Daily global foreign exchange turnover, 1989 to 2008 (US$ billions)   5.3 Daily average foreign exchange turnover, net of double-counting, by instrument (US$ millions)   5.4 Daily foreign exchange turnover and transactions costs, net of double-counting, by instrument, counterparty and currency, April 2004   5.5 Daily foreign exchange turnover and transactions costs, net of double-counting, by instrument, counterparty and currency, April 2007  

7 9 34 35 36 50 51 51 52 52 53 54 55 83 85 88 91 96 97 115 115 117 118 120

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5.6 Comparative analysis: the UK pound, annual turnover and transaction costs   5.7 Daily averages of trading transactions in the UK pound (in US$ millions), 2001 and 2007 compared   5.8 Special drawing rights allocations to IMF members since 1970   5.9 Calculated quota share of SDRs   5.10 Participants and credit amounts in IMF’s NAB and CAB arrangements   5.11 Foreign exchange turnover, net of local and cross-border interdealer double-counting, by instrument, counterparty and currency (in US$ millions)   5.12 Estimated reserves of foreign exchange and gold (as at December 31, 2008)   5.13 Emerging and developing economies (in US$ millions)   6.1 Some European corporate defaults in 2009   6.2 Macroeconomic data in time of crisis   6.3 Structural and cohesion funds received by Spain since 1986   6.4 Credit default risks as measured by credit default swaps prices (cost in US$ for a US$10,000 debt for 5 years)   7.1 Estimated global exposure to Greece’s default   7.2 Cost–benefit analysis of introducing the Economic Monetary System (EMS) in Germany   7.3 The Lisbon Agenda – Employment Rate Objectives   8.1 Case studies   8.2 Summary of ideas and fields used   8.3 Composition of self-made indexes  

121 122 126 128 132 133 133 135 153 166 166 172 187 192 201 221 226 233

Foreword Joaquín Almunia

This insightful and timely monograph by María Lorca-Susino is likely to meet the needs of a diverse readership: academics, policy-makers, and analysts of finance, economics, and European affairs. This broad appeal should not come as a surprise if one considers the topics chosen by the author and her courage in dealing with their complex and sensitive repercussions. The introduction of the euro and the creation of the Eurozone are among the greatest achievements of Europe’s process of integration. However important these achievements have been for financial and monetary policy and for the internal market, their significance is not limited to these domains. I have long held the author’s view that the euro has strong political, social, and cultural implications, which will become increasingly clear in the years to come. The present study also offers a timely analysis of recent events, as evidenced by its sections devoted to the economic and financial crisis that started in 2008 and that is—at the time of this writing—still with us. We can be proud of our common currency and of what it has done for the European Union over the past ten years. The euro has brought stability, trade and investments to the countries that have adopted it. The euro has also brought large benefits to the other countries of the EU, principally because it has shown what Europe can do when it stands united behind an ambitious project. Finally, the euro has become an international currency and a pillar in the global monetary system; as such, it has projected a strong image of Europe in the world and has become a symbol of our unity and determination. Since the end of 2008, the euro has helped the EU weather the economic and financial storm. The crisis hit just as the Eurozone was establishing itself as a model for the world to study and emulate and has since tested EU countries’ ability to play as a team both within the Union and on the world scene. I am convinced that the EU will once again manage to turn the formidable challenges of these months and years into fresh opportunities for the European project. The need for stronger and smarter supervision of the financial sector is one of the main lessons Europe has learned in these testing times. Over the past few years, supervision has remained largely national, while financial services have grown increasingly global. As a consequence, the case for a set of reforms that would adapt our regulatory frameworks to reality has become compelling. While dayto-day supervision will remain a national responsibility, common supervisory

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The Euro in the 21st Century

authorities will allow everyone to play according to the same rules; they will reconcile differences between national authorities; and they will make sure that EU law is applied correctly and uniformly. In this context, I would like to comment on the belief held by some that there is an inherent tension between regulatory and market forces. I regard this view as misguided for two main reasons: first, because a clear and coherent legal framework is essential in all areas of business and, second, because markets are not natural phenomena that occur beyond our control; they are human constructs and social institutions; they exist to serve society. In essence, a market is established, defined, and governed by a set of agreed conventions and formal rules set by society; there is no principled contradiction between regulation and the market. The application of EU competition rules is a good example. Competition policy ensures that markets are open, fair, and efficient; it creates a level playing field for all businesses and it ultimately brings benefits to enterprises and consumers alike. As to the broader policy implications, the current crisis has taught us that Europe needs to couple stability-oriented macroeconomic policies with structural reforms if we are to meet our goals for growth and social justice. Recent analyses carried out by the European Commission identify the creation of favorable conditions for entrepreneurship and innovation as priority areas. Swift and incisive policy initiatives can create a better environment for business in Europe, where companies can become more competitive and thrive. This will help Europe’s entrepreneurs to profit from the recovery in world trade driven by growing demand from emerging economies; perhaps one of the best routes that can take us out of the recession and put us back on track. I believe that economic policies are means to higher ends. To cite from “Europe 2020”—the overall strategy the EU has adopted as a beacon for all its policies in this second decade of the century—our efforts must be directed towards the creation of a smart, sustainable and inclusive economy delivering high levels of employment, productivity and social cohesion. I am happy to note that Dr. Lorca-Susino adopts a similarly broad outlook, explicitly linking the risks associated with soaring national debts to economic hardship on the ground and their likely consequences on the standards of living of our fellow European citizens. This is the most important reason why we need to take concerted action at European and national level; ensuring good economic policies is a matter for everyone’s concern. The European Commission will not tire in encouraging structural reforms across the EU. We will also continue to support policies that deepen and broaden macroeconomic surveillance. I am fully aware that the comprehensive and ambitious agenda we advocate requires a fair amount of political will, determination, and coordination among national authorities. Works such as The Euro in the Twenty-First Century are very useful in this respect, because they offer policy-makers a sound and impartial basis for their

Foreword

xv

debates, negotiations and deliberations. European citizens demand that budget cuts, austerity plans, and more flexibility go hand-in-hand with more and better opportunities, and enhanced social cohesion. It is the task of Europe’s leaders to heed this call and revive the success of the euro’s first roaring decade.  

Joaquín Almunia July 2010

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Acknowledgements I would like to acknowledge the help and support received from Dr. Joaquín Roy and Dr. Michael B. Connolly. Also, I would like to thank the academic ideas received from every single paper published by the European Union Center at the University of Miami under the Jean Monnet/Robert Schuman Paper Series and the European Union Miami Analysis (EUMA) Special Series. Finally, special thanks go to Dr. Bruce Bagley, Dr. Manuel Santos, and the University of Miami.

To my Family

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List of Abbreviations ACP Countries African, Caribbean, and Pacific Countries BDL Bank Deutscher Länder BRIC Countries Brazil, Russia, India, and China CAD Canadian dollar CAP Common Agricultural Policy CDS credit default swaps CHF Swiss franc CME Chicago Mercantile Exchange CO Crude Oil index COFER Composition of Official Foreign Exchange Reserves CPE central planned economy CPI Consumer Price Index CRB Commodity Research Bureau DAX German Deutscher Aktien IndeX 30 Dem German mark or deutsche mark DJIA Dow Jones Industrial Average D-mark German mark or deutsche mark EC European Community ECB European Central Bank ECOFIN Economic and Finance Council ECOWAS Economic Community of West African States ECSC European Coal and Steel Community ecu European currency unit EEC European Economic Community EFTA European Free Trade Association EMI European Monetary Institute EMS European Monetary System EMU Economic and Monetary Union ERM Exchange Rate Mechanism (ERMII after introduction of the euro, if distinction needed) ESCB European System of Central Banks EU European Union Euratom European Atomic Energy Community EURIBOR Euro Interbank Offered Rate € euro FDI foreign direct investments The Fed US Federal Reserve Bank

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Fed Funds Federal Funds Rate FRG Federal Republic of Germany GBP UK pound GDP gross domestic product GDR German Democratic Republic (formerly East Germany) GNP gross national product HICP Harmonized Index of Consumer Prices IGC intergovernmental conference IMF International Monetary Fund ITL Italian lira JER Joint Employment Report JPY Japanese yen LIBOR London Interbank Offering Rate LMU Latin Monetary Union NBER National Bureau of Economic Research NCB National Central Banks NYBT New York Board of Trade NYSE New York Stock Exchange OAPEC Organization of Arab Petroleum Exporting Countries OCA optimum currency area OECD Organization for Economic Cooperation and Development OEEC Organization for European Economic Cooperation OPEC Organization of Petroleum Exporting Countries PIIGS Countries Portugal, Italy, Ireland, Greece, Spain SDR special drawing right SEA Single European Act SEK Swedish krona SGP Stability and Growth Pact TFEU Treaty on the Functioning of the European Union technology, media, and communications TMT UK United Kingdom US United States of America UEMOA African Economic and Monetary Union USDX US Dollar Index USSR Union of Soviet Socialist Republics WAMZ West African Monetary Zone WWI World War I WWII World War II

PART I HISTORICAL AND THEORETICAL INTRODUCTION TO THE EURO

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Chapter 1

Historical and Theoretical Considerations This chapter uses a new regionalism approach to examine how the introduction of the euro has affected the so-called “new world order” in the twenty-first century and how the current economic crisis and financial uproar is affecting both the new order and the tenets of the new approach. The introduction of the euro created the Eurozone, a new region considered a supranational or world region with an important role in the current global transformation. The euro has demonstrated that although it was introduced as an economic tool for integration, it has a political, social, and cultural dimension. Thus, the euro has become a multidimensional form of integration because the actors behind integration are not only states, but also a large number of institutions and organizations with the political desire to strengthen regional coherence and identity. The Eurozone should be considered the core region because it is economically and politically dynamic and structured and the rest of the European Union (EU) and non-EU members relate to it. Particularly, this chapter explains how, under new regionalism, the Eurozone and the euro have helped increase not only economic, but also political, social, and even cultural homogeneity respecting diversity. Further, this book reflects that the current economic crisis and financial uproar has affected the new regionalism trend that began in the 1980s with the political and economic integration efforts in the EU and the Eurozone. The current economic events are affecting the integration process in the EU and the Eurozone in two dangerous but interesting ways. On the one hand, the economic crisis has negatively affected to different degrees the economies of some countries such as Portugal, Italy, Ireland, Greece, and Spain. In particular, Greece, Spain, and Portugal are in financial and economic positions that are halting the integration program, particularly financial and economic integration. On the other hand, these economic difficulties are pushing certain countries to look inward in a sort of defensive mechanism. Such is the case of Belgium, the UK, and in Spain, where national nationalism is suddenly being revamped and is now becoming more skewed than ever as the economic situation is getting worse. As a consequence, countries that were in line to adopt the euro are rethinking their view on becoming part of the Eurozone. Mainly, the impossibility of using monetary policy as a method of adjustment in the event of deep monetary problems, added to the lack of coordination among Eurozone Member States on how to tackle the current crisis, has also made certain countries wanting to join the EU and the Eurozone change their prospects. Furthermore, the current crisis has affected other integration projects such as Mercosur and the African integration. However, Asian countries



The Euro in the 21st Century

seem to be immune and January 1, 2010 has become a milestone date because it was the beginning of the China-ASEAN Free Trade Area. This agreement, which has an economic purpose in mind, is a “breeze of fresh air” for models for regional unity because “today, the free trade area is of greater significance amid the ongoing global financial crisis and rising trade protectionism when developing countries are more vulnerable because of their fragile economies.” (People’s Daily Online 2010) Finally, this chapter introduces an overview of the rest of the book’s contents and presents the book’s research design and methodological approach, because this book uses a number of time series and statistical approaches to strengthen its findings in order to provide the conclusion with a solid theoretical and statistical foundation. Also, Chapter 1 explains what have been the technical and theoretical difficulties found along the way. This chapter explains that the EU and the Eurozone suffer from an important lack of time series availability and variety. The fact that it is complicated, at best, to find the same time series for a number of countries in the same time frame and period of time makes any quantitative analysis complex. The Twentieth Century: Regionalism and the New World Economic Order The twentieth century witnessed dramatic changes in the state and nature of government and governance. This century endured two major world wars, a cold war, a major economic recession, and a number of minor ones. However, all these events seem to have taught that conflict and confrontation result in nothing but social misery and economic pauperism. Thus, although the first half of the century witnessed two world wars, the second half of the century put to work the lesson that cooperation is more productive than destruction. In particular, the end of the Cold War and the first stages of globalization made a number of geographically closed countries realize the benefits of cooperating and coordinating economic strategies to find synergies in a non-zero-sum game. The devastation of World War II and the economic situation in which most of world’s nations were immersed required the arrangement of the economic system, beginning with the urgency for fixing dangerous imbalances in the currency system in order to control currency fluctuations and allow commerce to flourish. After World War II, the world had to be completely reconstructed. The regionalist approach provided the right set of tools because, according to Wallis, regionalism was characterized for being all about government, structures, coordination, and power. For instance, regionalism was oriented towards empowering any one government with the mandate to “construct” and defend the nation while the world was going through one of the most turbulent periods of history. Regionalism was concerned about developing the public sector to create a backbone of government, which consequently was necessary to establish structures. The devastation of the two wars had left nations and governments

Historical and Theoretical Considerations



with almost no structure, and it was necessary to spend resources on the creation and organization of much-needed government and country structures for the efficient functioning of nations. Furthermore, regionalism was closed because it was concerned with defining boundaries and jurisdictions that ranged from the delimitation of national borders to the design of economic, political, and social policies that needed to be implemented. As a consequence, it was clear that countries were looking to coordinate how to best implement those policies, and as Allan Wallis (n.d., 4) explains, “coordination typically implied hierarchy; for example, a regional authority with powers to determine the allocation of resources to units of government within its boundaries.” Finally, all these four factors required accountability, which is a way of analyzing if the established goals have been accomplished and implementing corrective measures if they have not. A number of economic and monetary systems were put in place, and although none worked out completely satisfactorily, they were all stepping-stones rather than stumbling blocks and contributed to the need for cooperation at the economic and monetary level in order to strengthen synergies to enhance governance, government, and the living standard of the population. Thus, attempts at the monetary level unveiled the advantages of monetary and economic integration. The first stepping-stone that led to regionalism was the creation of the Bretton Woods System (July 1944–August 1971). During Bretton Woods, European currencies were under control because countries participating in the system signed an agreement in which national authorities were to submit their exchange rates to international disciplines. This system bolstered coordination and planted the seed for further cooperation and the beginning of regionalism. Under the Bretton Woods System, the US dollar was the numeration of the system, or the standard to which every other currency was pegged; this meant that other currencies were to peg their currencies to the US dollar and maintain market exchange rates within ± 1 percent of parity. At the same time, in order to bolster faith in the dollar, the US agreed to link the dollar to gold at the rate of $35 per ounce of gold. When the US economy began to weaken, loss of confidence in the dollar prompted other countries to redeem their dollar reserves for gold, further weakening US exposure. F.W. Engdahl (2004, 140) explains that “at the end of 1967, international holders of dollars went to the New York Federal reserve Gold Discount Window and demanded their rightful gold in exchange.” De Gaulle’s economic adviser, Jacques Rueff, went to London in January 1967 with a proposal for raising the price of gold, which would in turn mean the devaluation of the US and UK currencies. Washington refused to change the $35 per ounce official valuation of gold. Because the US was neither going to exchange dollars for gold nor change the gold valuation, France, the country that had most requested to redeem dollars for gold and was one of the largest holders of gold, withdrew from the system. Nonetheless, Engdahl (2004, 142) explains: France itself was the target of the most serious political destabilization of the postwar period. Beginning with the leftist students at the University of Strasbourg,



The Euro in the 21st Century soon all of France was brought to a chaotic halt as students rioted and struck across France. Coordinated with the political unrest (which, interestingly, the French Communist Party attempted to calm down), U.S. and British investment houses started a panic run on the French franc, which gained momentum as it was touted loudly in Anglo-American financial media. The May 1968 student riots in France were the response of the vested London and New York financial interests to the one G-10 nation which continued to defy their mandate. Taking advantage of the new French law allowing full currency convertibility, these financial houses began to cash in francs for gold, draining French gold reserves by almost 30% by the end of 1968, and bringing a full-blown crisis in the franc.

Under the Bretton Woods System, Germany’s industry became the most efficient and competitive sector in Europe, and its economy became the leader among those of other European nations. The secret of this success rested in Germany’s industrial ability to take advantage of increases in demand within its borders and within most European countries by maintaining strong productivity growth while keeping labor costs from rising and achieving sound export competitiveness. As Germany’s export surplus began to grow, becoming a national symbol of monetary and economic performance, economic imbalances began to surface for other European countries. In fact, most European “firms constructed their growth strategy mostly on extracting productivity growth without much investment but by using existing capacity” (Halevi 2005, 4). Germany, instead, would use those surpluses to modernize its industries, which helped to develop new products and improve productivity. The Bretton Woods System worked well as long as the US economy remained strong and countries agreed to hold dollars on the basis of their value in gold. Unfortunately, in the 1960s, due to the decline in the US’s balance of payments position, the system began to collapse. As a result, there was an oversupply of dollars held by foreign banks, and countries were less willing to hold dollars. These countries soon began to redeem their dollars for gold, resulting in a fall in gold reserves and an increase in the gold price. In August 1971, President Nixon announced that the US would no longer exchange dollars for gold, and the US dollar was removed from the Bretton Woods gold standard. After the collapse of Bretton Woods, currencies opted for a system of floating rates. However, this system soon proved not to be beneficial. In an attempt to restore order to the exchange market, ten leading nations made up of the European Economic Community (EEC) Member States, as well as the UK, Ireland, and Denmark, met at the Smithsonian on December 16 and 17, 1971. This partnership marked the first step in regionalism. Two days of negotiations resulted in a new system of exchange-rate parity that was called the “Smithsonian Agreement.” As Daniels and VanHoose (2004, 12) explain, “Although this new system was still a dollar-standard exchange-rate system, the dollar was still not convertible to gold.” Unfortunately, the Smithsonian Agreement collapsed within 15 months and a de

Historical and Theoretical Considerations



facto system of floating rates emerged. The reason for this collapse is explained by Mundell (2003, 12) as follows: The US monetary policy was expansionary in the 1972 presidential election year and the balance of payments deficit built up large dollar balances in Europe and Japan. In February 1973 the U.S. raised the official price of gold to $42.22 an ounce (where it remains to this day). This devaluation only served to whet the appetites of speculators and the crisis intensified. The market price of gold soared and exchange markets became turbulent.

After the collapse of this agreement, European countries realized that they really needed to seek currency stability and independence from the US dollar. This time they signed the Basle Agreement, on April 10, 1972, which had been designed as an intervention system of the central banks. This intervention system, commonly known as the “currency snake,” limited fluctuations between currencies and the US dollar to a maximum of 2.25 percent and fluctuations between any two currencies participating in the snake to a maximum of 4.5 percent. Unfortunately, this system failed mainly because economic events, led by US dollar fluctuations, made it impossible for the majority of currencies in the snake to remain within the fluctuation bands. Members participating in the snake were constantly leaving and entering. For example, the UK and Ireland left the snake in June 1972; Italy left in February 1973; and France left in January 1974, rejoined in July 1975, and left again in March 1976 (Schwartz 1983). By March 1973, only Germany and the Benelux countries remained in the snake system, underscoring once more the cohesion of the FRG economy and the strength of the D-mark. Furthermore, these events demonstrated that those countries that were not inclined to pursue price stability to avoid inflation were doomed. The lesson learned was that in order to have currency stability, countries must follow a uniform monetary policy. Consequently, Germany’s Helmut Schmidt and France’s Valéry Giscard d’Estaing did not give up on the dream of engineering a united Europe. To ensure currency stability, they originated the European Monetary System (EMS). Table 1.1 summarizes the dates of the various arrangements discussed above. Table 1.1

Monetary system date overview

System

Years

The Bretton Woods System The Smithsonian Agreement The Snake in the Tunnel The European Monetary System The Economic and Monetary Union

July 1947–August 1971 December 1971–1972 April 1972–March 1973 March 1979–December 1998 January 1999 to present



The Euro in the 21st Century

The Twenty-First Century: New Regionalism and the Current Economic Crisis and Financial Uproar At the time of writing (January 2010) the EU and the Eurozone are facing a difficult period. It seems that suddenly the integration process—widening and deepening— has come to an abrupt halt. On the one hand, there are no more countries “waiting in line” to join the EU, which gives a sense of emptiness. On the other hand, it seems as if the Lisbon Treaty impasse has stalled the deepening process, because there has been scant progress in integrating the EU in areas such as security, defense, immigration, and social policies. In addition, the four freedoms are still not fully implemented, and economic integration has not been accomplished. This situation has been worsened with the economic crisis and financial uproar that has made certain actors wonder about the EU project, particularly because economic and monetary integration successes have been the fuel necessary for the EU and the Eurozone to continue moving forward. The Lisbon Treaty impasse was the result of an implacable economic situation in Ireland that let society reject it, and in the UK, the vision of the euro changes with the economic difficulties of the country. Currently, the UK is facing one of worst recessions in history, and the actual position is that 75 percent of the population would reject adopting the euro (Tax Payers Alliance 2009). Finally, the current economic situation in Greece and the necessity for implementing harsh budgetary reforms are causing social upheavals and many complain about the prudence of remaining within the Eurozone and the EU. David Marsh (1993) explains that the European Monetary System (EMS), introduced on March 13, 1979, became the ultimate plan designed to obtain monetary cooperation among members of the European Union in order to finally provide the currency stability necessary for the introduction of a common currency. In order to achieve this goal, Member States had to work towards synchronizing their economies in many areas, which increased their feeling of belonging to a group. Because European countries trade more with each other than with the rest of the world, it made sense for them to transcend currency fluctuations and transaction costs in order to allow trade to flourish even more. As a consequence, the EMS came into effect in 1979 with the blessing of the Federal Republic of Germany (FRG), which wanted to ensure its export grounds and surpluses by putting European currencies under the control of the Exchange Rate Mechanism (ERM) (see Table 1.2). The EMS became a successful mechanism and was operative until December 31, 1998 when Member States fixed their currencies to the euro. The introduction of the EMS in 1979 launched many economies further into an expansionary economic cycle that boosted productivity, exports, employment, internal demand, and investment in both equipment and construction. This has been considered the new regionalism approach in action. Despite many setbacks, neither the political nor the economic project of a united Europe were abandoned, and the first stage of the Economic and Monetary Union’s (EMU) adoption of the euro was eventually introduced on July 1, 1990.

Historical and Theoretical Considerations



With the introduction of the EMU, the D-mark became the anchor currency and the Bundesbank became the de facto central bank for the other countries because it was doing the best job of keeping inflation low. The problem arose due to the strength of the German economy and the low-inflation policies of the Bundesbank, which ultimately forced other countries to follow its lead. Countries were able to follow the Bundesbank but, by the mid-1980s, were driven to use changes in interest rates to maintain their currencies within the bands. However, at the beginning of the 1990s, the EMS was strained by the differing economic policies and conditions of its members, particularly those of the newly reunified Germany, and a revision of the EMS requirements was necessary. The Brussels Compromise, in August 1993, awarded the EMS with a new fluctuation band of ± 15 percent. Table 1.2

Summary of monetary evolution from the Bretton Woods System to the European Monetary System

End of Bretton Woods in 1971

April 10, 1972

March 25, 1979

Treaty of Maastricht

The end of fixed exchange rate and the beginning of Floating Currency System.

Basel Agreement The Snake – to maintain currency fluctuation between the-/+2.25% bands.

European Monetary System (EMS) Currency fluctuation of +/-2.25% (6% for Italy).

Maintains the EMS system of currency fluctuation for those currencies willing to adopt the euro in January 1, 2000.

Despite all the ups and downs, the EMS worked well. Most importantly, the EMS ended with the imposition of rigid bands, which never helped to stabilize the currency, but rather attracted currency speculators. However, the EMS did help stabilize the currency to the point that—in the mid-1980s, when Jacques Delors became President of the European Commission—the momentum was perfect for the creation of the common currency. With the introduction of the euro, regionalism and its proposals made a step forward to a new regionalism approach. The new regionalism approach better explained the necessity to promote even freer trade and economic integration, because it was proven that regionalism had positive political effects. New regionalism has been called a “halfway house between the nation-state and a world not ready to become one” (McMahon and Baker 2006, 3). Allan Wallis stated that the interest in a newer version of regionalism was the result of the globalization of the economy that at the end of the Cold War allowed for “international trade agreements, like NAFTA, and the development of a European Community all demonstrate reduced economic competitiveness on a country-by-country basis, and increased competitiveness on a region-by-region basis.” This new approach was strengthened with the creation

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The Euro in the 21st Century

of the European Community and all the integration efforts it conveyed. The new regionalism approach explained that trade and broader economic integration has created a European Union in which another war between Germany and France is literally impossible. Argentina and Brazil have used Mercosur to end their historic rivalry … Central goals of APEC include anchoring the United States as a stabilizing force in Asian and forging institutional links between such previous antagonists as Japan, China and the rest of East Asia (Bergsten 1997, 1).

In fact, new regionalism is, according to Fredrik Söderbaum (2003, 1), “characterized by its multidimensionality, complexity, fluidity and non-conformity, and by the fact that it involves a variety of state and non-state actors, who often come together in rather informal multi-actor coalition.” According to Allan Wallis, the new regionalism approach is characterized by five key elements that perfectly well explain the foundation of the EU and the Eurozone. First of all, the European project is fundamentally concerned with governance, because the main role of institutions such as the European Central Bank or the European Commission is to set the goals of what must be accomplished, establish the rules, and implement the regulation necessary to achieve these goals. Furthermore, these goals are achieved through the implementation of a process. In fact, in order for countries to join the EU, it is necessary that certain objectives are met, which requires the implementation of a process rather than mere structures. Also, recommendations on certain structural reforms—for example, labor market reforms—advise the introduction of a number of processes intended to improve employment rates. Second, new regionalism is concerned with open boundaries, a concept implied in some of the policies that have been pooled from each nation, as well as the concept embedded in the four freedoms so characteristic of the EU. Third, new regionalism entails collaboration, a trait found in most of the Treaties and Directives, the Lisbon Agenda, or even in the newly introduced Europa 2020. Collaboration means canceling all coercive measures, which annuls the need to implement the necessary structural reforms because they can be implemented as collaborative rather than as punitive measures. This goes hand in hand with the fourth characteristic of new regionalism: that Member States operate on a basis of trust and not accountability. This means that Member States are trusted to implement the recommendations and not held accountable if they do not. For instance, the current economic and financial crisis has been deepened by the fact that some EU Member States had not been meeting the necessary requirements and were not held accountable for not doing so for years. The integration process is currently at a crossroads, however, because it has hardly been tested. The Lisbon Treaty impasse and the current economic crisis are testing the foundations of the Union to the point that support for the project is being negatively affected. In fact, different actors are beginning to raise doubts and concerns concerning the integration process. First, it is questioned as to

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whether globalization is still positive for the economic development of a nation. Second, there is close scrutiny as to whether the EU is still the best actor to defend nations’ battered economic interests. Certain countries are in the middle of a harsh economic recession, and certain actors are wondering if being part of the EU and the Eurozone is still in their best interests. Under these circumstances and feelings, it might be that the EU—borrowing but adjusting Barry Buzan’s idea—is no longer regarded by important powerful actors as a “regional economic complex,” understood as a group of states whose economic needs and concerns are so highly interlinked that it is almost impossible to differentiate the economic needs and concerns of any one of the nations in isolation. This is what the Eurozone and the EU is expected to have become, because the four freedoms, the introduction of the euro, and the objective of becoming a solid economic bloc should have forced economies to become one. The current economic crisis and the impasse of the Treaty of Lisbon have significantly weakened the project. Therefore, a thorough analysis of the European feelings recorded in the Eurobarometers demonstrate that under the current economic crisis and financial uproar, Europeans are falling out of love with the EU and the Eurozone and are in fact seeking to go back to the nation-state as a provider and defender of interests. In fact, Eurobarometer 71 (Eurobarometer 2009b) has reported significant shifts in public opinion about the EU and its institutions. A detailed analysis of these studies demonstrated that European public opinion on the role of the EU, globalization, integration, and enlargement has suffered a setback, which could eventually become negative for the support of the project. Eurobarometer’s analysis demonstrates that Europeans are drifting away from the global vision of the EU and turning to their national governments for coverage and even protectionism with renewed nationalistic feelings. This trend indicates that, under the current economic crisis, Europeans would rather trust their national government to help them cope than they would institutions of the EU. Eurobarometer 72 (2009c) reports that there has been a dramatic shift in opinions concerning the institution that Europeans believe could better handle the current economic crisis. Suddenly, Europeans are forming a growing consensus that national governments are better fitted to solve the current economic crisis than the institutions of the EU. In detail, whereas Eurobarometer 71 states that only 12 percent felt that their national government had the right tools to tackle the crisis while 21 percent defended the EU in this role, in Eurobarometer 72 (2009c), national governments had the support of 19 percent of Europeans while only 22 percent believed that the EU was better fitted to take effective action to deal with the current situation. This concludes that there is an increased inclination among Europeans towards the national governments. However, the EU is still the preferred actor. Nonetheless, this conclusion is strengthened by the fact that before 2008—when the current economic situation became a global issue—public opinion held that the EU was the best actor to take care of a harsh economic situation (Eurobarometer 2009c). This agrees with the public opinion that stated before the crisis that the EU had “sufficient power and tools to defend

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The Euro in the 21st Century

its economic interests in the global economy” (Eurobarometer 2009c). However, under the current circumstances, this confidence has decreased significantly. Special Eurobarometer 307 explains that 43 percent of Europeans believe that the national level is the level exercising the most impact on their daily lives whereas 9 percent believe it is the European level and 38 percent believe that it is the regional or local level. Also, 50 percent of Europeans believe that the regional or local authorities are the institutions to trust, against 47 percent who believe the EU is the best actor (Eurobarometer 2009). Concerning the future of the EU, in June 2007, 58 percent of Europeans felt fairly optimistic, whereas only 11 percent felt very optimistic (Eurobarometer 2007b). Finally, the current crisis has negatively affected the opinions of Europeans towards globalization, with 43 percent of Europeans believing that globalization presented a threat to employment and companies in their respective countries in November 2008, and only 39 percent believing it was a good opportunity (Eurobarometer 2008). As a consequence, Europeans have changed their opinion of the integration process as well as of the enlargement and the euro. Concerning the current speed of the ongoing integration process and the construction of Europe, the results evidence a desire to reduce the speed of building Europe (Eurobarometer 2005), which coincides with the fact that 55 percent of Europeans believe that “things are going in the wrong direction” in their country, with 39 percent having misgivings about the EU level (Eurobarometer 2008d). As a consequence, the images of the Eurozone and the euro have suffered a deterioration, and “more than two-thirds of non-member states citizens thought that their country should not rush into joining the euro area: 36 percent would like to have the euro introduced after a certain time and one-third as late as possible” (Eurobarometer 2008c, 3). Furthermore, the current economic crisis has affected European opinion on the euro’s introduction. In September 2007, 45 percent of the population favored the introduction of the euro, with 35 percent rather or very much against it. Two years later, the polls showed that in September 2009, 44 percent of the population favors it and 37 percent are against it. (Eurobarometer 2008c) Although this is not a dramatic change, it may indicate a trend. The impact of globalization on national economies and the current economic crisis force governments to put in place bailout plans, and yet economic and political nationalism have still emerged. These nationalistic feelings are strengthened because Europeans feel their economic security and standard of living are seriously threatened because there has been a “substantial loss of jobs in manufacturing; in recent years this has been particularly associated with companies moving their manufacturing plants to Eastern Europe, India, China, and the Far East” (European Movement 2006). Thus, according to Raymond J. Ahearn (2006), “since the summer of 2005, a number of EU member states have erected barriers to prevent cross-border mergers and acquisitions that undermine the effort to deepen the single market.” The latest Eurobarometer shows that 61 percent of Europeans believed in the middle of 2009 that the worst was still to come (Eurobarometer 2009c). This state of mind explains the recent revival of

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protectionism and nationalistic feelings. This situation is attacking the essence of the idea behind the single market and the basic foundation of the integration process. Curiously enough, this trend is coming from some Member States’ “governments (and or politicians) fearful of losing national prestige and jobs as a result of merger activity” (Ahearn 2006, 4). For instance, the UK’s Conservatives have clearly stated that if they win the upcoming election (in May 2010) they would never adopt the euro and that they will not be in favor of any more transfer of sovereignty to the EU without a proper national referendum. Chapters in this Book What follows is a brief introduction to the individual chapters. The purpose of Chapter 2, “The Euro as a Common Currency,” is threefold. First of all, this chapter summarizes the main tenets of the Optimal Currency Area (OCA) and explains the theoretical evolution of this theory since it was first presented by Robert Mundell, in 1961, in the paper titled “A Theory of Optimal Currency Areas,” until it was finally used as the theoretical framework for the creation of the euro in 1999. Secondly, this chapter succinctly overviews the most important attempts to introduce a monetary and economic union; thus, it reviews the various efforts taken since the Latin Monetary Union of 1865, up to the Delors Reports and the introduction of the Economic and Monetary Union. This chapter stresses the fact that all these failed attempts must be considered stepping-stones that had led to the perfection of a long-time dream: the introduction of a successful common currency. Finally, Chapter 2 analyzes integration attempts in Africa and in the Southern zone and compares these attempts with the EU and the Eurozone to identify a number of reasons why these two blocs are not making progress with their integration efforts. Today, the creation of the European Economic and Monetary Union (EMU) has proven to be a good shelter from the current economic storm, and the euro has become an anchor of regional stability and integration. As a consequence, the Eurozone has become an example to follow, and the common currency has come to be regarded as the solution that will end economic crises and prevent further ones. In light of these outcomes, the current chapter explains how African and Latin American countries are all reconsidering the importance of regional monetary integration. This chapter reviews the fact that many of these countries have already integrated into a number of trading blocs. This chapter also analyzes the fact that although the African effort is slowing down yet achieving results, the Latin American attempts have unfortunately proven to be crisis-prone as well as both economically and politically unstable. As a result, they have not been able to fully reach their trading potential, let alone achieve monetary integration. In light of these circumstances—and taking the Eurozone as a benchmark—this chapter addresses the economic and monetary sacrifices as well as the difficulties that all those countries willing to form a solid single market, and eventually a monetary union, must face and endure.

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The Euro in the 21st Century

Chapter 3, “Statistical Analysis of the Euro as a Stabilizer for the Eurozone,” analyzes whether the euro has truly become a common currency. In order to conclude affirmatively that the euro is a common currency and a stabilizing factor for the Eurozone, this chapter focuses on a thorough, innovative, quantitative analysis of the fitness of the euro as a stabilizing factor, using a vast variety of indexes in three markets: the foreign exchange market, the stock market, and the money market. First, the euro is studied in the foreign exchange market with the purpose of comparing and explaining the evolution of the euro vis-à-vis other currencies. Second, the evolution of the euro is analyzed to explain how the common currency is affecting the stock market cycles on both sides of the Atlantic, demonstrating that the introduction of the euro has helped synchronize stock indexes and provide European investors with wider investing opportunities. Furthermore, this chapter presents an interesting study that shows that the euro has helped keep inflation under control, which is one of the “musts” of the common currency. This study is presented with an innovative graphical analysis of the relationship between the evolution of crude oil, commodity prices, and the euro. Third, this chapter analyzes the euro and its impact on the money market indexes. This study is important because the European Central Bank uses the money market as an escape valve to fight inflation and to maintain price stability, and this will affect the money supply and the value of the euro vis-à-vis other world currencies. This section revises the US money market to provide a basis for understanding the money market in the Eurozone. This chapter becomes particularly innovative as it introduces three statistical studies. The first one is the covariance used to measure the extent that two random variables vary together, defined as Cov(x,y) = E{[x – E(x)][y-E(y)]}. The importance of this statistical method is that the result obtained will indicate the relationship, or lack thereof, between two random variables. For instance, when the result of the covariance is negative, it indicates that the two random variables have varied in opposite directions, meaning there is no linear relationship between the two. Also, the larger the magnitude of the product, the stronger the strength of the relationship. The covariance presented in the chapter is a custom-made formula that has been altered and programmed as a built-in effect in the Omega ProSUit 2000i computer program. This covariance has a length of 30 months (or periods) and has been programmed to move within a –0.35 to +0.35 range. The second statistical tool used is the “de-trend.” When a time series is de-trended, the secular trend is removed from the macro data: therefore, the cyclical and growth components of that time series is disentangled. De-trending a time series is a controversial aspect of the business cycle study because it implies transforming data, and some scholars believe this is a manipulation of pure data. However, detrending has been demonstrated to be particularly useful when studying certain time series exhibiting high volatility. Finally, a number of series has been studied using a 20-month simple moving average. A simple moving average is a statistical technique used to analyze a set of data points by creating an average of one subset of the full data set at a time with each number in the subset given an equal statistical weight. In this chapter, a 20-month simple moving average is used, which means

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15

a 20-month simple moving average of closing price is the mean of the previous 20 months’ closing prices. If those prices are: PM, PM-1, PM-2, PM-3 … PM-19, then the formula is SMA = {(PM + PM-1 + PM-2 + … + PM-19) / (20)}. Finally, each time a new data (month or period) is added to the time series, the entire moving average is recalculated to account for the new value added while dropping out the old one. The purpose of Chapter 4, “The Euro as an International and Global Currency,” is twofold: to analyze if the euro has become (a) an international and (b) a global currency. This chapter shows that the creation of the European Monetary Union and the introduction of the euro brought about an intense debate concerning whether or not the euro would manage to challenge the status of the US dollar and the hegemonic power of the United States consolidated since World War II. For this challenge, the euro had to first consolidate its position as a common currency, then gain recognition as an international currency, and finally become a global, or dominant, currency. As the euro gained international financial recognition, it became a stabilizing tool capable of furthering the political integration process of the EU. The euro has provided the economies of Europe with a degree of collective macroeconomic stability, flexibility, and economic transparency that individual Member States could never have achieved on their own. Therefore, the effect of the euro has been not only economically but also politically significant, because its inception as an international currency has provided enough weight to garner, for Europe, some of the political influences heretofore enjoyed solely by the US due to the hegemony of the dollar since World War II. This chapter studies whether or not it can be claimed that the euro has become an international and global currency. The results show that the euro has developed a solid market that has consequently eroded some of the advantages that historically supported the hegemony of the US dollar as a global, or dominant, currency. Hence, the euro can be considered an international currency; nevertheless, the US dollar remains the sole global currency. There are two correlated reasons that explain the reign of the US dollar. On the one hand, there is an inertia in the use of the US dollar due to years of currency preeminence. On the other hand, this preeminence has given the greenback an edge over the euro in terms of the size, credit quality, and liquidity of the dollar financial market over the euro financial market. The preeminence of the US dollar has helped the US exercise political hegemony, which has resulted in the “Pax Americana.” The euro has, nonetheless, transformed the Eurozone into a solid and internationally respected economic bloc with a wide area of influence and with an ever-increasing voice in the political and economic arena. However, these achievements have oftentimes been the target of fear and confusion as expressed by public opinion and representing the perspective of the euro-skeptics. Nevertheless, the reality is that the Eurozone has become viably competitive with the US for the first time in history. Chapter 5 explains that the current economic crisis and financial uproar that began in September 2008, globalization, and the necessity of achieving economies

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The Euro in the 21st Century

of scale and synergies to keep high competitiveness levels are all pushing to reform the current international monetary order. The current global monetary system is anchored in the US dollar at a point of time when the world has reached sophisticated economic and monetary synergies due to globalization forces. From a monetary point of view, the need for a new global monetary system is based on the fear that if the US government continues running the deficit to counter the worst recession since the Great Depression, the value of the US dollar will decline, negatively affecting the value of held assets in this currency, especially when almost 75 percent of today world’s currency reserves are held in US dollars. Consequently, it is believed that the current US dollar-based global monetary system must be revised and that a more inclusive system should emerge. This chapter explores two alternatives. First, some advocate the need for having an international reserve currency other than the US dollar, disconnected from any particular country, and find in the IMF’s Special Drawing Rights the right tool. Second, some proclaim the benefits of having a single, global, common currency and monetary system managed by a global central bank within a global monetary union. This chapter, therefore, explains that Robert Mundell, the father of the euro, has been advancing the idea of a global common currency for some time now, claiming that a reduction in the number of currencies in circulation will reduce transaction costs, increase price transparency, and force economic synergies. He has named this global currency the “intor.” It is not supposed to be a single currency; rather, countries and areas would keep their own currencies, which would circulate along with the intor. Further, Mundell has lately been advocating the need to have a fixed dollar–euro rate to avoid big swings in the exchange rate. He believes that implementing this fixed rate would be an easy and convenient way of increasing world trade because the US and the Eurozone make up almost 50 percent of the world economy. The introduction of a global common currency will have a direct impact on the foreign exchange market and its two participants—the customer and the market maker—because it would eliminate transaction costs for the customer and reduce benefits for the market maker. These transaction costs and benefits are measured by the spread between the bid price and the ask price in the foreign exchange market. This section presents the foreign exchange turnover by instruments—spot, forwards, swaps—in 2001, 2004, and 2007 to establish the importance that the FX market has gained over the last ten years. Second, it calculates the transaction costs for consumers and benefits for the market makers of the euro–sterling cross-rate in 2004 and 2007 to assess how the euro–sterling cross rate will affect the foreign exchange market if it were to join the euro and disappear. Finally, it analyzes the counterparties involved in this market, to shed light on which economic agent would be most affected if the pound were to cease to exist. Thus, this chapter analyzes the impact in terms of transaction costs of the UK pound by calculating the bid–ask spread and interprets it as a transaction cost that consumers face when exchanging pounds and euros and a benefit that market makers receive in these

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17

transactions. This study concludes that the pound is a financial instrument of great economic revenues, a “cash cow” for the market makers, and of great economic cost for consumers. The second approach to reinventing the international monetary system rests on the fact that the current global economic crisis has revived the role of the International Monetary Fund (IMF) and the purpose of the dormant Special Drawing Rights (SDR). The idea is for the SDR to substitute for the US dollar as the world reserve currency. However, the structure of the SDR and the IMF means that rich-country governments will end up dominating this new world economic order and limiting the access to the funds that emerging countries truly need. Nonetheless, many envision the IMF as a global central bank and the SDR as a common currency. Finally, this chapter elaborates on the fact that Brazil, Russia, India, and China are not only becoming increasingly important in the foreign exchange market, but also important advocates of a new monetary order, because they are major holders of foreign reserves. Chapter 6, moreover, presents an overview of the economic and monetary performance of Eurozone Member States, and it explains their current situation. It highlights that before the introduction of the euro, Portugal, Italy, Ireland, Greece, and Spain (also known as “PIIGS countries”) were in constant financial and economic turmoil, a situation that disappeared due to the economic prosperity of the past years and the economic and monetary sobriety that adopting the euro imposed on them. Nevertheless, PIIGS countries, also known as the “Garlic Belt,” have barely met the economic and monetary requirements imposed by Maastricht. As economic hardship intensified, these Eurozone Member States began to feel how their already feeble monetary and economic stability was becoming increasingly difficult to maintain and even more impossible to disguise. In fact, for the past years, PIIGS countries are not only suffering from excessive deficits and debts, but are also overwhelmed with other economic unbalances such as unmanageable and excessive current account deficits, which the current economic crisis is exacerbating due to, among other reasons, their extremely uncompetitive trade position. As a consequence, they are beginning to blame the euro. The problem that these countries are facing stems from the fact that monetary union amplifies fiscal imbalances, since opting for competitive currency devaluation is no longer an option and the only other alternative comes from forcing bond yield differentials down. This chapter shows that in 2005 there were almost no yield differentials between the German Bund and the yields of those countries with excessive current-account deficits. In 2009, however, yield spreads have become a worrisome reality, which has, in turn, increased government default risks measured by a sudden increase in the demand for credit default swaps (CDS). Hence, the current economic turmoil has in fact demonstrated that in a monetary union, currency risk is substituted by default risk, since the sovereign debt of each Member State is issued under the control of each Member State Ministry of Finance due to the fact that there is no European Ministry of Finance. The Treaty of Maastricht forces Member States to obey a common monetary policy, but when

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The Euro in the 21st Century

it comes to the fiscal requirements, each Member State is free to implement its own fiscal measures. Therefore, fiscal policy has become the “escape valve” to help offset monetary pressure. Most of the countries in dire straits are not complying with fiscal requirements, and it is argued that these countries should have been compelled by EU authorities with respect to the limits. However, there have been times when countries such as Germany and France were not respecting these limits either and were not punished. The problem is that Germany and France have an economic and fiscal structure completely different from Greece, Portugal, and Spain. Under the current economic turmoil, these scenarios have become a difficult liability to ignore and, in fact, Greece has become the focus of attention because its economic circumstances have almost caused the disintegration of the Union. This chapter touches on the problem in Greece to analyze the importance of the Stability and Growth Pact as a stabilizing factor. However, this chapter goes on to show how this fiscal instability is now present on the bond and equity markets, which in turn are negatively affecting the financial strength of not only those countries involved, but of the entire union. This chapter pays attention to understanding the state of the current account of many of the countries involved in this financial uproar because this account helps shed light on the current situation. This chapter concludes by thoroughly analyzing the economic, political, and social situation of Spain, another country that has brought grave concern to the stability of the EU due to its high public debt, current account deficit, and unemployment. Chapter 7 explains that, despite the euro’s runaway success during its first decade of existence, Eurozone governments must assume responsibility and strengthen efforts to coordinate and reform the economic, monetary, and social policies needed to maintain the solid performance of the EMU and the euro. This chapter shows that the Eurozone and the EU are at a crossroads where economic and fiscal reforms, and most importantly structural reforms, must be implemented to avoid a painful outcome. This crisis in Greece—the result of a continuous lack of transparency and hiding the real state of affairs—makes one wonder what has happened to the political class. In some countries, “long behind and forgotten” seem to be the principles put forward, curiously enough by classical Greeks such as Socrates, Plato, Aristotle, or Eratosthenes, whose works and philosophical views have much to do with theorizing on the idea of the perfect state or government. This chapter explains that, despite a number of asymmetric shocks preparing us for “thinking the unthinkable,” everything should be done to help the euro and the Eurozone survive. After detailing the dramatic events visited upon the Eurozone by Greek economic mismanagement, this chapter shows that the cost of participating in the euro has increased because this economic crisis has demonstrated that a common monetary policy might be inappropriate for certain countries. It warns that the cost of leaving the euro club is beginning to be imaginable, particularly if countries experiencing economic hardship default on their national debt, experience the collapse of their national banking system, or suffer civil unrest. However, withdrawal from the Eurozone is a complicated matter from both a legal standpoint—since it is not contemplated in any of the

Historical and Theoretical Considerations

19

treaties—and from an economic standpoint, since reintroducing a national currency would be difficult and painful. Despite the fact that withdrawing from the Eurozone is not a stipulated option, this chapter thoroughly examines the potential breakup of the Eurozone, if the economies of Eurozone Member States are not set back on track and a solution is not put into place. This chapter elaborates on the two possible scenarios to save the project. On the one hand is the prospect that Eurozone Member States do nothing to help defaulting countries. Another possibility is that Member States decide to help by offering bilateral funds to save a country in difficulties. This chapter also elaborates on the role of the IMF, because the actual legal framework has the “no-bailout” rule that prevents Member States from saving a country, which gives no other option to a country short of money than to turn to the IMF as a lender of last resort. Knowing the role of Germany is critical in understanding the behavior of the Eurozone Member States in the current crisis, because Germany is reluctant to help countries neither able nor willing to put their finances in order. However, this chapter explains that Germany does not want to see the disappearance of the Eurozone or of the euro, but is ready to let go of those countries that are not up to the test. Although Germany was ready to introduce the euro as a way to put certain countries on a leash—because these countries were using competitive currency devaluation to gain competitiveness against Germany—nowadays, Germany’s industries are so consolidated that if certain PIIGS countries were to reintroduce their national currencies, it would hardly affect Germany’s economy. Furthermore, the pursuit of competitiveness— via currency devaluation—must be analyzed in conjunction with the idiosyncrasy of the financial market and its impact on the economy. Introducing either the old or a new currency is extremely complicated. The immediate fate of the reintroduced currency is that it would be attacked by the market, which would automatically send the markets plunging; as a consequence, these countries would suffer from “euroization.” Going back to a new devalued currency is going to have a tremendous impact nowadays, not only when converting sovereign debt but, most importantly, when converting private debt held outside the country. The reason for this reluctance to lend financial help to certain defaulting countries is based on the fact that certain countries have not been willing to implement the type of structural reforms necessary to make themselves competitive. The EU and the Eurozone are not just suffering a financial crisis, but this financial crisis has its roots in a complete lack of necessary structural reforms. The proper functioning of the EMU depends not only on Member States adopting and complying with monetary and fiscal policy requirements, but on a number of structural reforms, especially in the labor market, required to foster economic growth and a stable euro. Before 1960 unemployment was not considered an economic issue that demanded worldwide attention; hence, research concerning unemployment was not taken into consideration, due to the fact that the unemployment rate within the European Community stood at less than 3 percent of the labor force. However, for the past twenty years the unemployment rate has increased dramatically in various countries. As a result of the economic and political impact of a significant

20

The Euro in the 21st Century

increase in unemployment, its causes and its consequences have become one of the most debated topics in recent years. The European Union Member States had many problems to solve when drafting the Treaty of Rome (1958). Since then, many of those same problems were considered priorities, giving scant attention to labor market performance, let alone the idea of full employment, until the Treaty of Amsterdam (1997). Unemployment was simply not considered a Community concern at the time, although, in 1990, unemployment was to become the EU’s most intractable economic problem (Van Oudenaren 1999). When the Maastricht Treaty was signed, in 1997, it was agreed for the first time that all efforts to fight unemployment were to be joined. This chapter discusses how the solution to this situation is not an easy one because failing to solve the Greek tragedy is failing to contain a problem that might arise in other PIIGS countries sooner rather than later. This chapter demonstrates that to respect their international debt obligations, highly indebted countries must run a trade surplus, which under current economic circumstances can only be achieved by forcing painful economic, monetary, and social transformations. In order to have a trade surplus, a country must improve its trade balances, which requires, at the minimum, a domestic demand contraction that must be offset by an increase in export levels, to avoid recession. Increasing exports levels is, in turn, contingent upon ameliorating trade productivity and competitiveness standards, which are highly related to human capital. The Eurozone cannot further delay any recommendations to push forward the structural reforms necessary to strengthen resilience and boost productivity that will, in turn, increase economic dynamism grounded on better performance. In fact, these highly indebted countries are continuously losing their positions on the European Innovation Scoreboard. Chapter 8 tries to demonstrate that the euro has become a solid common currency because it has become a stabilizing factor in a number of areas of the economy. Most significantly, the euro has helped keep inflation under control and has synchronized financial markets and eased the cost of accessing certain markets for investors. The purpose of this chapter is twofold. First, this chapter takes the euro as a common currency a step forward and proposes the creation of a innovative Euro Index similar to the US Dollar Index. Second, this chapter tries to demonstrate whether this index could be considered a strong leading index. The US Dollar Index (USDX) measures the value of the greenback relative to a basket of six major currencies—euro, Japanese yen, UK pound, Canadian dollar, Swedish krona, and Swiss franc—and each currency has a weight that reflects its trading relationship with the US. Similarly, because the euro is used to trade with major world countries and currencies, the Eurozone should have an index to measure its value relative to the majority of its most significant trading partners. In the case of the Eurozone, the index should measure the value of the euro relatively, not only to the US dollar, the Japanese yen, the UK pound, the Canadian dollar, the Swedish krona, and the Swiss franc, but should also take into account the increasing trading significance of Brazil, Russia, India, and China (BRIC). The importance of a Euro Index rests on the fact that it would present the euro as a common project

Historical and Theoretical Considerations

21

that will enhance and force further economic, financial, and political integration. The fact that the performance of the Euro Index could be compared and analyzed with the performance of the USDX improves market transparency, which in turn favors investors and consumer choices. This index will, consequently, become an economic and monetary indicator for the Eurozone, which will build on the prestige of the euro club enhancing not only the analysis of the Eurozone’s economic performance, but also predictions of future performance. This chapter therefore presents, on the one hand, four self-made foreign exchange indexes, the Euro Index, US Dollar index, the New Zealand Index, and the Australian Index, and, on the other hand, an innovative multidisciplinary approach used to interpret patterns in these indexes. The aim is to use this pioneering model to predict with some degree of certitude the pattern that a particular index will follow. This approach feeds from a series of theories and models put forward by scholars as diverse as Per Bak, George Cantor, and Henry Poincaré, among others, and contradicts the tenets of certain models and theories such as the Efficient Market Hypothesis, which posits (a) that the market follows a random walk that makes it impossible predict the next move and prevents investors from making profits, as well as (b) the behaviorist approach, which believes that markets are moved by the collective action of investors. These four self-made indexes are composed putting together various currency cross-rates. The reason for the creation of the New Zealand and Australian Indexes is that these indexes are used as a benchmark against which to compare the pattern used in the Euro Index. Furthermore, a self-made US dollar index using the same mathematical approach has also been created to be able to compare the Euro Index with it under the same premises. Curiously enough, the study shows that the New Zealand and the Australian Indexes could be classified as strong leading indexes whereas the Euro Index could be classified as a weak index because it lacks a strong convergence among its underlying cross-rates. Thus, an important tenet of this innovative approach is that although these are all indexes, the idea expressed in this study is that in order for these currency indexes to be leading there must be a strong convergence among their underlying cross-rates. This convergence can be traced using a mathematical approach because these cross-rates are a chaotic dynamical system that tends to converge and arrive at a critical point called the “attractor.” Convergence takes place when the covariance tends to zero. Therefore, this study explains that the self-made euro index follows these graphical and mathematical rules, but its cross-rates do not all converge. This chapter will graph and thoroughly explain each of the self-made indexes. The creation of the self-made Euro Index would be an important contribution to both understand and shed light on the euro as a common, international and global currency. The purpose of Chapter 9 is threefold. First, this chapter summarizes the book’s main findings. Second, it takes into account the limitations of this work. Third, it sets a number of recommendations. Chapter 9 summarizes the book’s main empirical findings: that the euro has become a successful common and international currency that has transformed the Eurozone into an economic,

22

The Euro in the 21st Century

monetary, and political model to imitate. However, this study highlights that the current economic crisis and financial uproar is taking a toll on the project because some countries are suffering harsh financial difficulties that, on the one hand, are dividing countries on how they handle this situation and, on the other, are making others reconsider their aspiration to join the EU. As a consequence, this financial crisis—just after the project is recovering from the Lisbon Treaty impasse—is bringing the integration process to a halt. Nonetheless, this book draws on the implications of these findings for theoretical and methodological debates on international economics and regionalism. This chapter discusses the book’s implications for current debates on the prospects of the Eurozone’s survival, arguing that recent economic developments highlight the bloc’s enduring economic and political rationale and raising questions about its longer-term coherence and sustainability. Current economic hardships are testing the economic maturity of Eurozone Member States, some of which are going through challenging times and are putting an extra burden on the other Member States. As a consequence, since the introduction of the euro, some have been arguing for the Eurozone’s demise while others have praised it as a way of weathering an economic storm. Ultimately, the future of the Eurozone depends on the ability of Member States to resolve current economic and monetary tensions between supranational strategic incentives as well as individual Member States’ political and economic constraints on cooperation. In fact, this chapter concludes that the breakup of the Eurozone—which was considered to be unlikely—has suddenly become no longer trivial. Despite the fact that leaving the Eurozone is such a complicated option, some countries may consider themselves to be better off leaving the EU altogether. A breakup of the Eurozone will lead to the collapse of economic, monetary, social, and political structures not only of the Eurozone but also of the EU as a bloc. Hence, this chapter emphasizes the necessity of a strong political class fully committed to the EU project and prepared to implement a painful set of necessary reforms for its sake. This greatly needed political class must emphasize the importance of maintaining the necessary reforms that will sustain the euro, because such efforts have been proven to work. This chapter, therefore, concludes that there is a lack of what can be called “euroization” that must be rectified in order for the euro to truly act as an integrating force, and it highlights that the Eurozone and the EU are missing the vision of true statesmen for the future of the project that certainly is in need of a new productive model. This chapter also exposes the limitations found along the way. The main limitation has been the difficulty of finding unified macroeconomic data to be able to analyze and strongly assert conclusions. The main problem found in this field was that not all countries submit the same information, and oftentimes when they do, time frames do not coincide, which renders a cross-time analysis of particular series in a number of countries exceedingly difficult. This book therefore exposes the fact that the Eurozone and the EU should definitely improve data collection, and it would even be valuable if a there could be an institution—such as the National Bureau of Economic Research—in charge of analysis and reporting on

Historical and Theoretical Considerations

23

business cycle issues. For the EU and the Eurozone to group their data indicators into “leading,” “coincident,” and “laggard” would be of great help to the academic community. Finally, this chapter presents two recommendations that would help improve and secure the EU and the Eurozone project. The first is that the EU should avoid creating more institutions and strive to make the ones that already exist respected and obeyed. Amid the current economic crisis and financial uproar, many officials have proposed the creation of more institutions to introduce more rules and regulations that must be respected as a “vaccine” to “cure” the current “illness.” They fail to realize that the current “disease” is not because there was a lack of measures, but because these were not obeyed. The second recommendation is that the EU should understand that if, in case of financial difficulties, countries cannot exit, the EU and Eurozone must implement the right type of measure to ensure the correct observance of the requirements necessary to make the system work. Otherwise, if they are not going to execute this surveillance role, there should be the possibility for a “misbehaved” country to leave the Eurozone or the EU altogether to avoid jeopardizing the project. Nonetheless, the actual Treaty of Lisbon has been already breached, not only because the no-bailout rule is broken but, most importantly, because there are a number of countries that have been for some time not respecting the requirements, thus completely breaking the Treaty.

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PART II THE EURO AS A COMMON, INTERNATIONAL, AND GLOBAL CURRENCY: AN EMPIRICAL STUDY

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Chapter 2

The Euro as a Common Currency The adoption of the gold standard remained in effect until 1971when President Nixon eliminated the fixed gold price, and the Bretton Woods System disappeared. The demise of this system was followed by a period of monetary instability, which in the case of European countries led to the introduction of the euro as a common currency. The introduction of the euro has, therefore, been considered the most dramatic change in the monetary system since the adoption of the gold standard in the latter part of the nineteenth century. Before the euro was nominally introduced on January 1, 1999 and physically introduced on January 1, 2002, each country had its own currency representing the sovereignty of each nation and its people. When the time came to reach an agreement on a common European currency many disputes ensued regarding what its format and essence would be. The original idea for a common European currency came from the Nobel Prize winner, Robert Mundell, and his theory on Optimal Currency Areas. Back in 1970, Robert Mundell presented his work at the “Conference on Optimum Currency Areas” in Madrid. At this conference he presented a paper entitled “A Plan for a European Currency” (Mundell 1973a) in which he illustrated the gains that European countries would obtain by adopting a common currency, which he proposed to name the “Europa.” Following the conference, Lorenzo Bini-Smaghi, a senior staff member of the European Monetary Institute (EMI) asked Mundell if he had been the originator of the idea to name the currency “Europa.” Mundell explained that he thought that the popular usage would most likely end up being abbreviated as ¨euro” instead. In 1970 Bini-Smaghi invited Mundell to the European Monetary Commission and asked him how long it would take to create the European currency, to which Mundell (2002b, 10) replied, “it is more difficult than you think. Even if there were no political impediments, it would take at least three weeks.” It took three decades. Today, the creation of the European Economic and Monetary Union (EMU) has proven to be a good shelter for the weathering of the current economic storm, and the euro has become an anchor of regional stability and integration. As a consequence, the Eurozone has become an example to follow, and the common currency has come to be regarded as the solution that will end economic crises and prevent further ones. In light of these outcomes, this chapter explains how African and Latin American countries are all reconsidering the importance of regional monetary integration. This chapter reviews the fact that many of these countries have already integrated into a number of trading blocs: it also analyzes the fact that while the African effort is slowing down yet achieving results, Latin American attempts have unfortunately

28

The Euro in the 21st Century

proven to be crisis-prone as well as both economically and politically unstable. As a result, they have not been able to fully reach their trading potential let alone achieve monetary integration. In light of these circumstances, and taking the Eurozone as a benchmark, this chapter addresses the economic and monetary sacrifices and the difficulties that all those countries willing to form a solid single market, and eventually a monetary union, must face and endure. The Optimal Currency Area: Theory and Debate Mundell’s depiction of the adoption of the euro as “the most dramatic change in the international monetary system since President Nixon took the dollar off gold in 1971” (Bergsten 2005b, 2) places the creation of the EMU and introduction of the euro among the major economic, political, and historical events of the twentieth century. In fact, the only other case of successful monetary unions that can be compared to the introduction of the euro is that of the greenback after the Civil War of 1861–65. Nonetheless, the idea of a common currency aimed at solving the various economic disadvantages associated with different monies is not new. Both the US and the UK proposed the importance and convenience of having a world currency when planning the new post-war economic order at the 1944 Bretton Woods summit. Under President Roosevelt and the then Secretary of the Treasury, Henry Morgenthau Jr., the US presented the White Plan—named after the Treasury’s economist, Dr. Harry D. White—which included the provision of a dollar-based new world currency called the “unitas.” The UK, guided by John M. Keynes, also proposed a pound-based currency called the “bancor.” Both currencies were only meant to play the role of an accounting unit. Later on, in 1969 the IMF introduced a new international reserve asset, the Special Drawing Right (SDR), to support the Bretton Woods fixed exchange rate system. Unfortunately, in 1973 the Bretton Woods System collapsed and the major currencies shifted to a floating exchange rate regime. The SDR was introduced because “gold and the US dollar proved inadequate for supporting the expansion of world trade and financial development that was taking place” (IMF 2008, 1). Therefore, the international community decided to create a new international reserve asset under the auspices of the IMF. At the time of the signing of the Maastricht Treaty, the monetary union was still a much-debated issue; scholars, economists, and politicians alike were struggling with the pros and cons of such a union. The decision to give up one’s national currency and adopt a common one is based on a determination of the costs and benefits that relinquishing national monies to adopt a common currency would have for a group of countries. Still, today, some countries either do not understand or do not choose to accept the notion that a world engaged in global trade should just as well share a common currency. As the originator of the idea to adopt a common currency in Europe, Robert Mundell’s work as focused on its feasibility and desirability has been classified

The Euro as a Common Currency

29

by Ronald McKinnon (2004) into two categories: “Mundell I” and “Mundell II.” This classification is based on the evolution of Mundell’s thoughts on this issue. In 1961, Mundell employed a Keynesian perspective in a paper entitled “A Theory of Optimal Currency Areas.” Later, in 1970 in Madrid, during a conference on optimum currency areas, he presented two major papers, “Uncommon Arguments for Common Currencies” and “A Plan for a European Currency.” According to McKinnon, the 1961 paper can be labeled “Mundell I,” and the Madrid papers, influenced by the new monetary economic vision of the 1980s, represent “Mundell II.” “Mundell I” expressed some skepticism about the benefits of a common currency area and believed in “making currency areas smaller and more homogeneous— rather than larger and more heterogeneous—while emphasizing the advantages of exchange rate flexibility” (McKinnon 2004, 691). The theory of Optimum Currency Areas (OCAs) of 1961 studies how countries with a monetary union and common currency adjust when affected by asymmetric economic shocks. Mundell claimed that adjustments are based on whether wages are rigid, labor mobility is limited, income transfers are difficult, and differences exist in the labor market and growth rates. According to him, countries with a monetary union and a common currency would not be able to properly absorb asymmetric shocks unless, among other circumstances, labor mobility is a reality. “Mundell II” emphasized the benefits of a common currency in overcoming economic shocks because “the common currency assures an automatic and equal sharing of the risk of the fluctuation” (Mundell 2003, 119). This idea, which triumphed under the Maastricht Treaty, was explained in Mundell’s (1973b) article “Uncommon Arguments for Common Currencies.” Following his view, the European Commission’s (1990) document, entitled “One Market, One Money,” sets forth a defense arguing for the benefits of a common currency in terms of microeconomic and macroeconomic stability, and the opportunity to improve equality among countries and regions of the Eurozone. The Path to the Economic Monetary Union (EMU): From the Latin Union to the Euro The path to the EMU and the euro has not been an easy one. The nineteenth and twentieth centuries witnessed a number of major attempts to achieve European monetary integration. A monetary union is not simply achieved when a number of countries adopt a common single currency; it also requires an effective exchange rate between Member States as well as the adherence of all countries to a common monetary policy. History has demonstrated that trade and commercial relations tend to be higher among countries with geographic proximity, which sparks the need for a monetary and economic union. In the nineteenth century, the first attempt was the Austro-German monetary union (1857–66). The second attempt was the Latin Monetary Union (1865–78) between France, Belgium, Italy, and Switzerland. The third attempt was the creation of the Scandinavian Monetary Union (1875–1917)

30

The Euro in the 21st Century

between Denmark, Norway, and Sweden. Furthermore, the twentieth century witnessed a world divided into two political blocs, which implemented monetary and economic unions. On the one hand, the world witnessed the particular way in which the Union of Soviet Socialist Republics (1922–91) understood and implemented the idea of a monetary and economic union. On the other hand, the European Commission (n.d.), in “The EMU: A Historical Documentation,” explains that only two attempts at monetary integration occurred during the twentieth century. The first attempt occurred at the 1969 Den Haag summit, during which the Werner Report was introduced. This report represented the first commonly agreed plan of action to create an economic and monetary union in October 1970. The second attempt was the creation, in 1979, of the European Monetary System (EMS) and the introduction of the European Currency Unit (ecu) as common currency. The main purpose of this second initiative was to set up a zone of monetary stability and to increase efforts to achieve closer economic convergence between Member States. Thus, the history of Europe reveals that, over the years, there have been many efforts aiming for the achievement of an economic and monetary union and the establishment of a common currency. Fortunately, after all these failed attempts came the successful creation of the EMU and the euro. Nevertheless, every single failed attempt has, without a doubt, left an imprint, which has also led to a final and successful attempt. In April 1989, Jacques Delors outlined what became known as the Delors Report—a thorough, three-stage plan—to introduce the EMU via a process that culminated with the final introduction of a common currency, the euro, on January 1, 1999 in 11 of the 15 member states. On that date, the euro currency became a reality, and the single monetary policy as a major underpinning was introduced under the authority of the European Central Bank (ECB). Although the conversion rate for the euro was put in place on January 1, 1999, actual euro notes and coins were not introduced until January 2002; this was an intentional delay meant to provide a three-year transition period for the 11 countries adopting the euro. Thus, 11 national currencies legally ceased to exist on December 31, 1998. On January 1, 1999, 11 out of 15 EU countries freely chose to adopt the euro and the Eurozone was born. Greece, which was unable to meet the convergence criteria to join in 1999, finally qualified in 2000 and was admitted to the Eurozone on January 1, 2001. Denmark, Sweden, and the UK did not adopt the euro; these three countries are part of the EMU but are still not part of the Eurozone. Of the ten   Denmark has an “opt-out” clause from the Maastricht Treaty. The country held two referendums and both rejected the adoption of the euro. The latest public referendum took place in 2000.  Sweden has to join the euro as stipulated by the 1994 Act of Accession agreement. However, at first, Sweden did not meet the economic conditions to join the Eurozone; and later, in 2003, a public referendum resulted in a rejection of euro membership.   The UK has an opt-out from Eurozone membership under the Maastricht Treaty. The UK meets the economic conditions for joining the Eurozone; however, its government has not yet put the question to public referendum.

The Euro as a Common Currency

31

new countries that joined the EU in 2004, Slovenia qualified in 2006 to adopt the euro in January 2007, and Cyprus and Malta adopted the euro on January 1, 2008. Slovakia eventually joined on January 1, 2009. As a result, in 2009 the Eurozone had a total of 16 Member States. The creation of the Eurozone is a unique endeavor that stands as a model to imitate because of the integration force of the EMU as well as the successful role of the euro. In fact, the economic stability achieved after the introduction of the euro has been an incentive attractive enough to propel Member States toward the pursuit of further integration at the political and social level. The euro has amply demonstrated the many benefits of a common currency. Some authors believe that economic and monetary integration entail political integration, while others believe political integration entails economic and monetary integration. The majority of scholars, however, agree that a political union could only be achieved once an economic and monetary union is set, and that political union is necessary to strengthen the other two. In fact, De Grauwe (2006, 728) believes that although the EMU is a remarkable achievement, “the absence of a political union is an important flaw in the governance of the Eurozone.” Nonetheless, there is a continuing effort to complete political integration in the EU, given its past success at economic and monetary integration. There is an important difference between the previous unsuccessful monetary unions and the EMU. While the previous monetary unions rested on the value of gold or silver, or metallism, the EMU rests on the euro, or chartalism, as fiat money. Metallism or bimetallism is a monetary system in which the value of the currency unit is expressed in amounts of gold or silver, and where the “exchange rate” is fixed by law. This system is very stable mainly because gold and silver are scarce resources and because, as a result, governments can only print as much money as can be backed up by the stock of gold or silver stored. Fiat money, on the other hand, is issued by a central national bank, and its value and stability depends on the good credit of the issuing authority. This good credit, in turn, is based on the political and economic stability of the country. However, fiat monies are less stable because of the temptation of the inflationary tax or seigniorage when the Treasury is unable to finance the deficit. In the EMU, stability has mainly been achieved through the introduction of the following two pillars: an economic union and a monetary union. Economic union is achieved by complying with the Stability and Growth Pact (SGP), which is based on the implementation of specific fiscal requirements among EMU Member States with the goal of maintaining fiscal stability. Monetary union is based on the existence of the euro as a common currency and the implementation of a common monetary policy supervised by a central bank in this case, the European Central Bank (ECB). The introduction of a common interest rate by the ECB, and the requirements of the SGP have encouraged further integration because they have fostered the synchronization and harmonization of economic behavior or the business cycle. This leads Rose (2000, 2) to believe that “business cycles are systematically more highly correlated between members of

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The Euro in the 21st Century

currency unions than between countries with sovereign currencies.” In fact, since the introduction of the euro the business cycles of the Eurozone and of the US seem to have reached a high degree of synchronization, as is represented in Graphs 2.1 and 2.2 below.

Graph 2.1

European Commission Euro Area Business Climate Indicator

Source: Bloomberg Finance LP

Other Monetary Unions: Success or Failure? As a result of the synchronization between the business cycles of the Eurozone and the US, the euro is viewed as a successful common currency capable of promoting convergence among economies of different sizes and natures. Since its inception, it has been closely watched by other areas willing to follow in the footsteps of the EMU and the euro. This is particularly the case for many Asian countries. Haruhiko Kuroda (2008, 1) has stated that “the euro has played an essential role in fostering harmony among diverse economies. This experience is extremely useful for Asia, as the region moves ever more resolutely towards its own style of regionalism.” This also applies to African countries, which are finalizing the idea of clustering into groups to create monetary and/or economic unions; and to Latin America which is rethinking its own integration process. The success of the euro rests on the fact that the Eurozone is a full monetary union. Full unions, such as the Eurozone, are characterized by having a monetary authority embodied in a single joint institution, normally a central bank. In the Eurozone, the ECB, together with the central bank of each Member State, creates the European System of Central Banks (ESCB). As Mundell (2002b, 126) puts it, with the EMU and the adoption of the euro, “each country sacrificed its policy sovereignty in the field of its own money in exchange for its share of policy sovereignty in the direction of the ECB.” He also explains that the implications of

N ov -0 M 0 ar -0 1 Ju l-0 N 1 ov -0 M 1 ar -0 2 Ju l-0 N 2 ov -0 M 2 ar -0 3 Ju l-0 N 3 ov -0 M 3 ar -0 4 Ju l-0 N 4 ov -0 M 4 ar -0 5 Ju l-0 N 5 ov -0 M 5 ar -0 6 Ju l-0 N 6 ov -0 M 6 ar -0 7 Ju l-0 N 7 ov -0 M 7 ar -0 8 Ju l-0 N 8 ov -0 M 8 ar -0 9 Ju l-0 N 9 ov -0 9

110

105

100

95

90

85

80

Graph 2.2 US Conference Board, US Leading Index of 10 Ten Economic Indicators

Source: Bloomberg Finance LP

The Euro in the 21st Century

34

the creation of the euro and the replacement of national currencies are extremely important for the countries involved in this initiative because “the right to produce a national currency has, for centuries—even millennia—been looked on as a principal dimension of political independence and a badge of legal sovereignty” (Mundell 2002b, 127). There is also what is called a “pseudo,” “incomplete” or “intermediate” currency union. Pseudo, intermediate, or incomplete unions are, according to De Grauwe (2007, 121), those formed by “countries in the world [that] peg their currencies to another one, in particular to the dollar … to form an ‘incomplete’ monetary union with the country to which they peg.” For Mundell (2002a, 135), “in a pseudo currency area, monetary policy may be allocated to domestic objectives.” There are many examples of incomplete unions that become fragile. This fragility is due to what De Grauwe (2007, 121) calls a problem of “credibility.” According to Eichengreen (2002, 21), the intermediate union “forces governments to choose between credibly and unconditionally subordinating monetary policy to the exchange rate.” In fact, the success of the Eurozone as a full union lies in the fact that “the ECB and the European System of Central Banks … were given the mandate to maintain price stability and to safeguard the credibility of the euro” (Trichet 2008c, 5). Table 2.1

List of existing and de facto monetary unions

Existing monetary unions 1. 2. 3. 4. 5.

The euro in the Eurozone The East Caribbean dollar in Anguilla, Antigua and Barbuda, Dominica, Grenada, Montserrat, Saint Kitts and Nevis, Saint Lucia, Saint Vincent, and the Grenadines The CFA franc (BEAC) used by Cameroon, the Central African Republic, Chad, the Republic of Congo, Equatorial Guinea, and Gabon (Hadjimichael and Galy, 1997 CFA franc (BCEAO) used by Benin, Burkina Faso, Côte d’Ivoire, Guinea-Bissau, Mali, Senegal, and Togo The East African shilling used in the East African Community (EAC) by the Republics of Kenya, Uganda, Burundi, Rwanda, and the United Republic of Tanzania

De facto monetary unions 1. 2.

The euro is legal tender in Andorra, Kosovo, and Montenegro The Hong Kong dollar is used in Macau (Bank of Hong Kong)

3.

The Russian ruble is used in Russia and the Georgian Autonomous republics of Abkhazia and South Ossetia (McMullen 2008) The Swiss franc is used in Liechtenstein The US dollar is used in Palau, Micronesia, the Marshall Islands, Panama, Ecuador, El Salvador, Timor-Lester, the British Virgin Islands, and the Turks and Caicos Islands

4. 5.

The Euro as a Common Currency

Table 2.2

35

List of planned monetary unions

Name

Currency

Date

West African Monetary Zone, as part of Eco the Economic Community of West African States (ECOWAS)

December 2009, revised to January 2015

Gulf Cooperation Council (GCC)

Khaleeji

2010, revised to 2013–2020

Caribbean Single Market and Economy (CSME) as part of the CARICOM

Unknown

Due between 2010 and 2015

Southern African Development Community

Unknown

2016

De Grauwe (2007, 121) explains that the collapse of systems like Bretton Woods in 1973, the Economic Monetary System in 1993, and the unions among South-East Asian currencies in 1997–98 and Latin American currencies in the 1990s, were all the result of “the fragility of a fixed exchange rate system [that] has everything to do with credibility.” In contrast, the strength of the Eurozone rests precisely on the credibility of the requirements set when the EMU was being implemented and the ECB was established. However, if these requirements are no longer met nor respected by Member States, the Eurozone might soon suffer from a lack of credibility that will negatively affect the project. Table 2.1 lists the number of existing monetary unions which include the Eurozone and some others that exist with a certain degree of difficulty. Furthermore, Table 2.1 list the de facto monetary unions which are areas where a particular currency has been adopted as legal tender although that particular country does not belong to the economic and monetary union where that currency is the common currency. Table 2.2 lists the number of planned monetary unions. A thorough analysis of Table 2.2 shows that some of the expected currencies have not been introduced. For instance, the ecu as a common currency has not been introduced in 2009 and the date has been revised for January 2015. Similarly, the khaleeji was scheduled for 2010 but now has been postponed until sometime between 2013 and 2020. The African Attempt: An Integration Conundrum African countries, with the exception of Morocco, have grouped into an intergovernmental organization, the African Union (AU), established on July 9, 2002 as a result of a dispute with the Sahrawi Arab Democratic Republic. It was conceived by the Libyan leader Muammar Gaddafi who proposed a “United States of Africa: with a structure that loosely resembles that of the EU” (BBC News n.d.). The main objective of the AU is to foster the political and socioeconomic integration of the continent in order to strengthen peace, security and human rights; a set of goals that much resemble the founding goals of the EU. The AU also seems to share a very similar institutional structure with the EU. For example,

36

Table 2.3

The Euro in the 21st Century

Recognized regional economic communities (RECs)

The Arab Maghreb Union (UMA) The Common Market for Eastern and Southern Africa (COMESA) The Community of Sahel-Sahara States (CEN-SAD) The East African Community (EAC) The Economic Community of Central African States (ECCAS) The Economic Community of West African States (ECOWAS) The Intergovernmental Authority on Development (IGAD) The Southern Africa Development Community (SADC)

the AU has an Assembly which functions as its decision-making organ, a PanAfrican Parliament with 265 members elected by their national parliaments, other institutions such as the Economic, Social, and Cultural Council (ECOSOCC) which is a civil society that functions as a consultative body, and a number of financial institutions such as the African Central Bank, the African Investment Bank, and the African Monetary Fund. However, the AU has taken a unique approach to achieve economic and monetary integration. While the EU is an economic and monetary union of 27 Member States, the AU’s integration efforts rest on eight regional economic communities (RECs) summarized in Table 2.3. The 1980 Lagos Plan of Action for the Development of Africa and the 1991 Abuja Treaty which established the African Economic Community (AEC) proposed that the economic and monetary integration of the African continent should depend on the integration of these eight sub-regions. Thus, these eight regional economic communities form the pillars of the AEC. The AEC seeks the creation of an economic and monetary union, as in the case of the EU, by implementing free trade areas, customs unions, a single market, a central bank, and a common currency. The Abuja Treaty, signed in 1991 and initiated in 1994, established that by 2028 the AEC should have integrated and established a continent-wide economic and monetary union with full circulation of a common currency. However, this desire lacks any solid economic structure upon which the creation of a common currency can rest. The EU established a set of standards that countries had to respect in order to guarantee some degree of economic and fiscal uniformity among its members. A brief economic analysis of these countries shows that they all share the same low GDP per capita (Graph 2.3) except for Equatorial Guinea and Gabon. When it comes to inflation, Graph 2.4 shows that some countries are suffering from an exceptionally high inflation rate—a threat to any common currency. In fact, this graph shows that almost all of the countries experience rates that are well above 100 percent, and even Ghana and Guinea, which curiously enough are the two countries with the highest GDP per capita, bear rates of close to 500 percent. This proves that these countries are lacking all kinds of economic, monetary, and fiscal structure.

The Euro as a Common Currency

Graph 2.3

37

GDP based on purchasing power parity (PPP) per capita in selected AEC countries

Source: Global Finance magazine

Graph 2.4

Inflation in selected AEC countries

Source: Global Finance magazine

One of the RECs which follow in the footsteps of the EU model is the Economic Community of West African States (ECOWAS), a regional group of 15 African countries founded on May 28, 1975, with the signing of the Treaty of Lagos. It aims   Member States of the ECOWAS are Benin, Burkina Faso, Cape Verde, Cote d’Ivoire, The Gambia, Ghana, Guinea, Guinea Bissau, Liberia, Mali, Niger, Nigeria, Senegal, Sierra Leona, and Togo.

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The Euro in the 21st Century

at promoting economic integration among its members. Curiously enough, the ECOWAS Member States are divided into two different economic and monetary unions: the West African Economic and Monetary Union (UEMOA) and the West African Monetary Zone (WAMZ). First, UEMOA is a customs and monetary union with the CFA (Communauté Financière d’Afrique) franc as a common currency whose exchange rate is tied to the euro, is guaranteed by the French Treasury and is issued by the BCEAO (Banque Centrale des Etats de l’Afrique de l’Ouest). On January 10, 1994, Benin, Burkina Faso, Cote d’Ivoire, Mali, Niger, Senegal, and Togo signed a treaty in Dakar in which they agreed on a number of objectives oriented towards increasing competitiveness, macroeconomic convergence, and the creation of a common market. The IMF 2003 report on the area explains that the bloc has increased its external competitiveness as well as the pace and range of its economic integration. However, the strong economic expansion of the area after the devaluation in 1994 of the CFA franc has tapered off despite prudent monetary policy pursued by the regional central bank. Furthermore, the CFA franc is also used in a number of countries in central Africa such as Cameroon, the Central African Republic, Chad, the Republic of the Congo, Equatorial Guinea, and Gabon. The CFA franc of central Africa is issued by the Bank of the Central African States (BEAC, after the original French name of Banque des Etats de L’Afrique Centrale). Both the West and Central African CFA franc have the same value. It is important to highlight that some of the countries included in the ECOWAS have left the UEMOA because to be part of the union was jeopardizing the project: other countries such as Guinea, Mauritania, and Mali left and, after devaluating, rejoined years later. Second, on December 1, 2000 Gambia, Ghana, Nigeria, and Sierra Leona joined forces to create the West African Monetary Zone (WAMZ) with the goal of introducing the “eco” as a common currency by 2015 (Obayuwana 2009) and as a rival to the CFA franc. However, by 2020 both currencies, the CFA franc and the eco, are expected to merge, preceded by the launching of a monetary union, with the establishment of a regional central union for the area. These various measures and groupings are summarized in Figure 2.1. Latin American Attempts: Objectives, Successes, and Shortcomings Many attempts aiming at integration using a political approach have been made among Latin American countries; however, as the case of the EU demonstrates, only those attempts using trade and economics as the main approach toward integration stand a chance. Currently, in Latin America, Mercosur and the Andean Community of Nations (CAN) are the most important and successful trading agreements withstanding. In fact, in Cusco, Peru, in December 2004 during the Third American Summit, these two trading blocs signed a cooperation agreement and published a joint letter of intention (Preamble to the Foundation Act of the South American Union) in which they stated that their aim was to work together

The Euro as a Common Currency

Figure 2.1

39

Progress of ECOWAS

towards the integration of all of South America in what was called the South American Community of Nations. The Constitutive pact explains that Their determination to develop a politically, socially, economically, environmentally and infrastructurally integrated South American area that will contribute toward strengthening the unique South American identity and, from a subregional standpoint and in coordination with other regional integration experiences, that of Latin America and the Caribbean and will give it a greater weight and representativeness in international forums (Comunidad Andina 2004).

Furthermore, the Preamble called for the creation of a regional parliament, a common market, a constitution drafted with the EU as a model, and even a common currency. None of this has happened; thus this project has stalled, with the creation of the single market to eliminate tariffs expected by 2018: the gradual implementation of the four freedoms is still under review. However, member states created the South American Bank which was launched with a capital of US$7bn to finance economic development projects, a task that has nothing to do with the mandates of the ECB. The reason why this project is at a standstill is explained by the fact that the integration process of Mercosur and CAN are also at an impasse since these two underlying trading blocs have not followed their pre-established integrating path. However, if the South American Community of Nations were

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The Euro in the 21st Century

to become operative, it will bring together 387,948 million people and create a trading area of 6,846,154 square miles. Many similarities can be drawn when analyzing the efforts of these blocs on opposite sides of the Atlantic. Furthermore, as the creation of the EU and the Eurozone have proven to be extremely beneficial for the area, Mercosur and CAN will surely be equally beneficial for Latin America. Mercosur and CAN have achieved some level of accomplishment but have followed an erratic path due to economic setbacks and a lack of commitment. If these blocs want to succeed, it seems that they should follow in the footsteps of Europe as the EU has proven to be the only integration attempt that has worked. The EU is a fully developed common market and the Eurozone is a successful economic and monetary union under the supervision of the newly agreed Treaty of Lisbon and a set of institutions that overviews the integration process. The success of the EU and the creation of the Eurozone can be briefly explained as based on three foundations that are highly intertwined. First, according to Ana I. Eiras and Brett D. Schaefer (2001) the integration process rests on the existence, among Member States, of strong economic and political stability which establishes the grounds for mutual trust and a common willingness to give up the same level of political and economic sovereignty to develop a common project. Secondly, the EU rests on the creation of institutions whose legally binding resolutions are respected and complied with by all Member States which, in turn, fosters political integration. Finally, economic and monetary integration is achieved by a strict adherence to a list of requirements. In the case of Mercosur and CAN these three premises are absent in varying degrees.

Graph 2.5

GDP based on purchasing power parity (PPP) in Mercosur full member countries

Source: Bloomberg Finance LP

The Euro as a Common Currency

Graph 2.6

41

Inflation in Mercosur full member countries

Source: Bloomberg Finance LP

From an economic point of view, Mercosur member states do not share many economic characteristics. First of all, as Graph 2.5 demonstrates, the GDP per capita in all four countries is quite uneven, with Brazil having the highest level and Uruguay and Paraguay representing one fourth of Brazil’s. By the same token, inflation, which is one of the main requirements for a sound economy with a solid common market, is extremely high in all four member states. Graph 2.6 shows that inflation has been increasing since the year 2000. Finally, as Graph 2.7 demonstrates, the state of their current account balances shows a very mixed picture. The current account in the balance of payments of a country measures that country’s economic health by indicating whether it has a surplus or a deficit. Curiously enough, Argentina has been running surpluses which

Graph 2.7

Current account balances in Mercosur full member countries

Source: Bloomberg Finance LP

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The Euro in the 21st Century

significantly increased in 2009. These surpluses were aided by a trade surplus that was characterized by a slump in imports in the second quarter of 2009 (Popper 2009). On the other hand, Brazil is enduring a significant deficit (particularly in 2009) due to, according to Gerald Jeffris and Tom Murphy (2010), “a fall in the profit and dividend remittances and the fact that the country’s imports fell more than exports.”

Graph 2.8

Alternative measures of political and economic integration— six countries compared

Sources: Fraser Institute, “Freedom of the World: 2008 Annual Report,” at (accessed November 2, 2009); The Economist Intelligence Unit, “The Economist Intelligence Unit’s Index of Democracy 2008,” at (accessed November 4, 2009); World Economic Forum, “Competitiveness Reports 2008–2009,” at (accessed November 23, 2009)

The history of Mercosur shows that Brazil and Argentina suffer from a political instability that prevents these countries from having a stable economy. This simple premise has developed a “hidden” lack of political and economic trust which has consequently developed a strong unwillingness to give up national sovereignty. Graph 2.8 compares a number of measures that indicate the level of economic and political stability in Argentina and Brazil in relation to Germany, France, the UK, and the US Consequently, the Democracy Index elaborated by the Economist Intelligence Unit (2008) graded Brazil and Argentina as “flawed democracies” due to the fact that certain freedoms have been eroded; the other countries in this graph are considered full democracies. Furthermore, the World Economic Forum (2008–09) presents a “Global Competitiveness Index” that measures the level of institutional development, macroeconomic stability, and policy instability in the

The Euro as a Common Currency

Graph 2.9

43

Economic freedom—six countries compared

Source: Fraser Institute, “Freedom of the World: 2008 Annual Report,” at (accessed November 2, 2009)

area. The index shows that in terms of institutions, both Brazil and Argentina have a poor score since Argentina ranks 128 and Brazil 91 out of 134 countries, while European countries and the US are in the top 25, proving that these countries have achieved a high level of integration in terms of institutions. Consequently, the score for macroeconomic stability is very poor in Brazil and Argentina and the level of policy instability is very high, particularly in Argentina. This demonstrates that low economic policies and political instability prevent these two countries from achieving a worldwide noteworthy position despite their potential. Finally, political instability will take a toll on the economic freedom of Argentina and Brazil; Graph 2.9 shows that both countries already have the very low levels of economic freedom. In the case of the European countries, the level of economic freedom increased after 1980 when efforts to fully develop the EU and create the Eurozone became an objective agreed upon by Member States. In the case of Argentina and Brazil, after the Treaty of Asunción was signed in 1991 and Mercosur was launched, economic freedom increased. It remains almost identical for both countries, yet it remains below the European level. The Brazilian maxi-devaluation of 1999 and the 2001 Argentine default on the larger part of its public debt brought about economic mistrust between these two countries, bringing the Mercosur integration process to a standstill. When economic difficulties hit one country, the other country, rather than helping in a common effort to make it through, sought shelter outside the bloc. In the case of Brazil in 1999, Argentina tried to insulate itself by adopting the US dollar as a national currency, a policy that further impeded Brazil’s recovery. By the same token, when Argentina defaulted on its almost $132bn public debt (Voice of America 2001) it affected Brazil, whose currency lost almost 30 percent of its

44

The Euro in the 21st Century

value against the US dollar (Businessweek 2001). Furthermore, Mercosur lacks the existence of a country that can act as an economic anchor, since the two major countries—Brazil and Argentina—are in almost constant economic disarray; this is a situation that each country tries to solve using country-specific measures, which proves that Mercosur members lack common political and economic policies. Finally, in contrast to the EU project which only initially required the economic assistance of the US, Argentina and Brazil continue to be economically and politically dependent on nations like the US, Germany, Japan, and, recently, China. This fact hinders internal development. Furthermore, although the Additional Protocol on the Institutional Structure of Mercosur (Ouro Preto Protocol) was signed on December 17, 1994 to boost the creation of institutions that help with the legal personality of the organization and to set a mechanism in place to make decisions and force agreements, Mercosur lacks the institutional infrastructure necessary to organize the integration process and enforce legally binding regulations agreed upon by Member States. The problem lies in the fact that achieving political integration through the deepening of institutions would be very difficult since both Argentina and Brazil experience difficulties in maintaining stable institutions at home. Therefore, setting institutions at a supranational level becomes rather difficult. Nonetheless, Bouzas and Soltz explain that in Mercosur: In contrast to the detailed, rules-based approach of the North American Free Trade Agreement (that includes a total of 245 articles crammed in over 1,200 pages), the Treaty of Asunción and the Ouro Preto Protocol laid a broad and flexible framework to foster regional integration. They also differ from the Treaty of Rome in the detail of the commitments undertaken by the signatories, the nature of governing organs, the role given to an “autonomous” legal order and the procedures adopted for decision-making.

The Treaty of Asunción (ToA) created the Common Market Council (CMC) in charge of working towards a common market. The purpose was to bring together the ministers responsible for economic affairs and foreign relations. Furthermore, the Common Market Group (CMG) included each Member State’s ministers responsible for foreign relations, economic affairs, and central banks, with the mandate to cooperate in order to boost economic integration. In 1994, the Ouro Preto Protocol (OPP) created the Trade Commission (MTC), the Joint Parliamentary Commission (JPC), and the Economic and Social Consultative Forum (ESCF). Of all these institutions, only the Trade Commission was designed as a decision-making organ with powers to dictate “directives” oriented toward the enforcement of common trade policies. The rest of the institutions are counseling and advisory organs. This structure and organization is far from the institutional rigor found in the creation of the EU and the Eurozone. Graph 2.10 shows the level of corruption, inefficiency, and even the possibility of government instability (or coups d’état) for Argentina and Brazil compared

Graph 2.10 Some problematic factors for political integration—six countries compared Source: World Economic Forum, “The Global Competitiveness Report 2009–2010,” at (accessed December 2009)

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The Euro in the 21st Century

to those in the EU and the US. Curiously, Germany has the lowest levels while France, the UK, and the US rank higher in terms of the level of government inefficiencies. From an economic integration point of view, much is still to be done in Mercosur, which is still considered to be just a customs union while the EU is a single market with a de facto free movement of people, services, goods, and capital, whose members have agreed to comply with common policies on trade, such as agriculture and fishing, and on regional development. Furthermore, Mercosur, created in 1991, has still, in 2009, been unable to fully reach a solid customs union, let alone the next stage of economic integration: the single market. In the European case, the EU was born in 1951 with the European Coal and Steel Community; in 1957 with the Treaty of Rome it became the European Economic Community (EEC), and in 1968 internal tariff barriers were abolished. However, the integration project stood still until 1986 when the Single European Act was signed, establishing, by 1993, the single European market which allowed for the freedom of movement of goods, labor, and capital. By 1999, 13 of its Member States went on to the last step of economic integration. In the EU there continues to be a debate concerning the final steps toward complete political integration in light of past successes in economic and monetary integration. Some authors believe that economic and monetary integration entail political integration, while others believe that political integration entails economic and monetary integration. The majority of scholars agree that a political union could only be achieved once an economic and monetary union is set, and that political union is necessary to strengthen the other two. In fact, De Grauwe (2006, 728) believes that although the EMU is a remarkable achievement, “the absence of a political union is an important flaw in the governance of the Eurozone.” This is consistent with the latest findings on integration that conclude that “political integration is not rapidly followed by economic integration. Instead, we estimate that it takes at least one generation (between 33 and 40 years or more) to remove the impact of political borders on trade” (Nitsch and Wolf 1). Thus, founding nations of Mercosur, CAN, or the South America Community of Nations must work towards improving their national political institutions to strengthen economic development and mutual trust among nation states as the only sure recipe for achieving solid integration. Final Words The creation of the EU and the introduction of the euro as a common currency have demonstrated that economic and monetary cooperation is possible among countries. The essential point is not only that cooperation is possible but also that it is more importantly desirable to improve economic development, political stability, and social well-being in a country and a group of countries. The fact that the European countries that had been involved in two devastating wars were capable of cooperating under the umbrella of the EU and the euro has become a

The Euro as a Common Currency

47

model to imitate. This chapter explains that to introduce the euro has not been an easy task, although the idea had been around for many years and with different formats. Finally, after a number of failed attempts, the euro has been introduced in a number of Member States. This chapter demonstrates that the introduction of the euro has been such a total success that the euro as a national currency has been adopted by other countries that are not even part of the Eurozone. This is important because the significance of a national currency is also measured by the number of countries that unilaterally, or via a specific agreement, adopt that currency as a national one. This chapter also explains that there are a number of countries that have followed the evolution of these European countries in their quest to create a union and introduce a common currency. The fact that, after the creation of the EU and the introduction of the euro, countries have improved economically, politically, and socially has been an incentive for a number of countries and regions. The countries of Latin America comprise the first important region that has been trying for quite some time to create a union: there have been many attempts but almost all have also failed. Mercosur is the most important attempt as it has the presence of the two economic giants of the area: Brazil and Argentina. However, evidence demonstrates that the incentive to continue the common effort of all four countries is at an impasse. Brazil seems to be aware that its economic development is on the way with or without the cooperation of Argentina, Paraguay, and Uruguay. In fact, Brazil has become (together with China, India, and Russia) one of the most important developing countries. As a consequence, Brazil has raised the living standard of its citizens and has become an important economic global actor, thus allowing it to focus on developing other areas. For instance, Brazil is for the first time looking into improving its national security and defense: in 2008 it put together for the first time in history a national defense strategy framework and raised national defense spending by 50 percent. On the other hand, at the time of writing in early 2010, Argentina is in a middle of a political crisis that is affecting the economy, as the political fight between the President and the Central Bank of Argentina is disturbing the economic state of affairs. Another problem for integration in this region is that there is a complete lack of trust among countries which prevents any efforts at integration. Mercosur, after all these years, cannot be considered a fully developed customs union. Furthermore, this chapter has explained the integrating attempts of some of the African countries which are already trying to introduce a common currency. However, there are many setbacks and obstacles to be overcome. Although having a single market and an economic and monetary union is extremely appealing, as it truly increases economic expansion and social progress, this is no easy task to achieve. The example of the EU and the Eurozone demonstrates that it takes clear institution organization, political commitment, and social sacrifices to have a successful story. The study of the integration efforts of these two blocs has revealed that both the African and the Latin America blocs lack, to a different degree, these three main characteristics. Dangerously, the current economic crisis and financial uproar is negatively affecting the progress that these regions had achieved throughout the years.

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Chapter 3

Statistical Analysis of the Euro as a Stabilizer for the Eurozone Since the mere idea of the euro was envisioned the prediction was that the euro was never going to become a reality. During the first stage of its introduction, the naysayers predicted that the euro was destined to have a very short life and become another very expensive failed attempt to “unify” Europe. As the euro began to turn into a reality, the debate switched to discussing whether the euro would ever become a successful common currency strong enough to transform the Eurozone into an optimum currency area. The argument was that most of the individual countries adopting the euro were not prepared to maximize the economic efficiency derived from sharing a common currency due to their different economic, monetary, political, and social backgrounds. Skidelsky (2001, 9) states that “monetary union is a political project pursued by economic means.” However, the success of this project rests on how the common currency affects the economies of the Member States after its adoption. A monetary union can, indeed, only be considered optimal if the introduction of a single currency helps the “(1) maintenance of full employment; (2) the maintenance of balanced international payments; [and] (3) [the] maintenance of a stable internal average price level” (McKinnon 1963, 717). This shows that there is a strong correlation between employment and stability in price levels, which, as Friedman states, are two of the most important benchmarks that will determine the success of the union. In fact, Friedman (1976, 3) explains that “the effects of a change in aggregate nominal demand on employment and price levels may not be independent of the source of the change, and conversely the effect of monetary, fiscal or other forces on aggregate nominal demand may depend on how employment and price levels react.” Ten years after its introduction, many still doubt that the euro is a common currency. This chapter demonstrates that today the euro is a de facto solid common currency and that the Eurozone is, in fact, an optimum common currency area. According to theory, a successful common currency must be able to help reduce the asymmetric shocks produced by a negative externality. This chapter examines how the euro has been able to cope with an increase in the price of oil and commodities, with the fluctuation in the stock market and the currency market across the Eurozone, and with the evolution of the labor market and consumer prices. The main focus of this study is to examine whether the euro has been an economic, monetary, fiscal, and social stabilizer for the Eurozone. In order to do this, the underpinnings of the euro are analyzed in this chapter. Moreover, the requirements and benchmarks that have to be achieved, maintained, and respected are tested

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50

against the data found in two major statistical data sources: the European Central Bank’s Statistics Data Warehouse (), and E-signal. This chapter focuses on a thorough quantitative analysis of the fitness of the euro as a stabilizer using a vast variety of indexes. For this purpose, this chapter studies the evolution of 18 indexes (Table 3.1) analyzed by means of 34 graphs. Table 3.1

Summary of indexes

US Dollar Index (USDX) German deutsch mark (D-mark or Dem) Euro French franc (FRF) Spanish peseta (ESP) Italian lira (ITAL) UK pound (GBP) Dow Jones Industrial Average (DJIA) Eurotop 100 German Deutscher Aktien IndeX (DAX) Crude Oil (CO) Commodities Research Bureau (CRB) US 2-year Treasury Note Eurodollar (3 months) US 10-year Treasury Note German Bund LIBOR (1 month) EURIBOR (3 months)

The foreign exchange market is the first market studied to analyze whether the euro has become a successful common currency. In order to do this, the foreign exchange indexes and currencies are analyzed as listed in Table 3.2. The currencies used for this study—the German mark, the Spanish peseta, Italian lira, and French franc—no longer exist as national currencies; however, Future Source is a data vendor that still carries their daily values (). The stock market is the second area analyzed to study how the introduction of the euro has affected some major stock indexes and also to study the impact of the euro on investors’ investment opportunities (see Table 3.3). This section also includes an innovative study to analyze the relationship between the euro and the price of oil and commodities. There is an important relationship between them as the prices of oil and certain commodities do have a direct effect on the price of certain necessities, thus affecting price stability and inflation.

Statistical Analysis of the Euro as a Stabilizer for the Eurozone

Table 3.2

Summary of currencies analyzed

Graph

Index

3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9 3.10 3.11 3.12

US Dollar Index (USDX) US Dollar Index with 20-month simple moving average and de-trended Deutsch mark composite D-mark and US Dollar Index Evolution of the euro Euro and US Dollar Index Deutsche mark composite and euro French franc (FRF) and euro Spanish peseta (ESP) and euro Italian lira (ITL) and euro Euro and UK pound (GBP) Euro and UK pound since 1981

Table 3.3

51

Summary of stock exchange, Crude Oil, and CRB Indexes

Graph

Index

3.13 3.14 3.15 3.16 3.17 3.18 3.19 3.20 3.21 3.22 3.23 3.24 3.25 3.26 3.27

Dow Jones Industrial Average (DJIA) DJIA with 20-month moving average and de-trended Deutscher Aktien IndeX (DAX) DAX with 30-month moving average and de-trended DJIA and US Dollar Index DAX and euro DAX and DJIA DJIA and DAX with covariance DJIA, DAX, and Eurotop 100 Crude Oil and CRB Indexes Crude Oil and CRB Indexes with covariance CRB Index and US Dollar Index Crude Oil and US Dollar Indexes Crude Oil and US Dollar Indexes with covariance Crude Oil Index and euro

As a direct consequence of the evolution of the price index and inflation, the European Central Bank (ECB) decides on the “price of money” and adjusts the money markets accordingly. For this reason, the third market analyzed is the evolution of the money market and its relationship with the euro (Table 3.4).

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52

Table 3.4

Summary of money market indexes

Graph

Index

3.28 3.29 3.30 3.31 3.32 3.33 3.34

US 2-year Treasury Note and Eurodollar (3 months) US 10-year Treasury Note 10-years and Bund Eurodollar (1 month) and Eurodollar (3 months) EURIBOR (1 month) and Eurodollar (3 months) EURIBOR (3 months) and LIBOR (1 month) EURIBOR (3 months) and euro Euro and Bund

Technical Matters and Computer Program Technicalities This chapter presents a total of 34 graphs to investigate three markets: the foreign exchange market, the stock exchange and commodities market, and the money market. These graphs have been created using two different advanced graphing programs, and permission to reproduce has been granted. First, Graphs 3.2, 3.14, 3.16, 3.20, 3.21, 3.23, and 3.26, have been plotted with the consent of the Omega Research Pro-Suit 2000i program. This is a professional program which only plots data in Metastock form. In order to convert Excel data into Metastock readable data, a professional data converter program, the Downloader, was used. Second, the rest of the graphs presented in this chapter have been plotted using Future Source. Furthermore, these graphs plot a wide variety of custom-made indexes, strengthened by the statistical reliability of a number of significant statistical methods such as the covariance, de-trend, and simple and exponential moving averages. Table 3.5 provides a summary of which graphs have been analyzed. Table 3.5

Summary of statistical study

Graph

Index

Covariance

3.2 3.14 3.16 3.20 3.23 3.26

US Dollar Index (USDX) DJIA DAX DJIA and DAX CRB and Crude Oil Indexes Crude Oil and USDX

√ √ √ √ √

De-trend

Moving Average

√ √ √

√ √ √

The first statistical analysis used in this work is the covariance. The covariance was first introduced and used by Jean Le Rond d’Alembert, a French mathematician who put together the d’Alembert Criterion which basically is used to measure the level of convergence of series of positive terms. This criterion specifies that if the positive terms series tend to less than one, these series are converging, and if

Statistical Analysis of the Euro as a Stabilizer for the Eurozone

Table 3.6

53

Custom-made covariance formula

Inputs: IndependentVal(Close of Data1), DependentVal(Close of Data2), Length(30); Plot1(Correlation(DependentVal, IndependentVal, Length), “Covariance”); Plot2(0, “Zero Line”,BLACK); Plot3(.35, “COV POS”,BLUE); Plot4(–.35, “COV NEG”,RED); {Alert Criteria} If Plot1 < .35 Then Alert(“There is a strong positive correlation in the last”+NumToStr(length,0)+” bars”) Else If Plot1 > –.35 Then Alert(“There is a strong inverse correlation in the last”+NumToStr(length,0)+“bars”); Condition2 = PLOT1 > –.35; Condition3 = PLOT1 < .35; if CONDITION2 then setPlotColor(1,green); if condition2 then setplotwidth(1,6); if CONDITION3 then setPlotColor(1,red); if CONDITION3 then setPlotwidth(1,6);

these series tend to more than one the series are diverging. Convergence is used to measure to what extent two random variables vary together and it is defined as Cov(x,y) = E{[ x – E(x) ][ y – E(y) ]}. The importance of this statistical method is that the result obtained will indicate the relationship, or lack thereof, between two random variables. When the result of the covariance is negative, it indicates that the two random variables have varied in opposite directions, meaning that there is no linear relationship between the two. On the other hand, positive covariance implies that both variables enjoy a linear relationship and are moving in the same direction. Finally, the larger the magnitude of the product the stronger the strength of the relationship.

54

Table 3.7

The Euro in the 21st Century

Custom-made de-trended formula

Inputs: Price(Close), Length(N) N = 20; PLOT1(0,“CERO”,“Cero Line”); PLOT2(CLOSE–XAverage(Price, Length), “DETREND”); {Alert Criteria} CONDITION1= PLOT2 < 0; CONDITION2 = PLOT2 >0; if CONDITION1 THEN setPlotColor(2,red); if condition1 THEN setplotwidth(2,6); if CONDITION2 THEN setPlotColor(2,green); if CONDITION2 THEN setPlotwidth(2,6); {Alert Criteria} condition2= plot1 > +0 and plot1 < plot1[12] and plot1 < plot1[14] and plot1 < plot1[16] and high = highest (high,16) and high–low > high[1]–low[1] or plot1 = lowest(plot1,16); condition3= plot1 < –0 and plot1 > plot1[12] and plot1 > plot1[14] and plot1 > plot1[16] and low = lowest (low,16) and high–low > high[1]–low [1] or plot1 = highest(plot1,16); {Alert Criteria} if (CONDITION2 ) then setPlotColor(1,red); if (CONDITION2 ) then setPlotwidth(1,5); if (CONDITION3 ) then setPlotColor(1,green); if (CONDITION3 ) then setPlotwidth(1,5); if condition2 or condition3 then alert;

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For this chapter, the covariance used is a custom-made formula that has been altered and programmed as a built-in effect in the Omega ProSuit 2000i computer program. This covariance has a length of 30 months (or periods) and has been programmed to move within a –0.35 to +0.35 range. The formula used is explained in Table 3.6. Also, three of the figures analyzed in this chapter have been “de-trended.” When a time series is de-trended the secular trend is removed from the macro data, hence the cyclical and growth components of that time series are disentangled. Detrending a time series is a controversial aspect of the business cycle study because it implies transforming data and some scholars believe this is a manipulation of pure data. Nonetheless, Nobel Prize winner Simon Kuznets used this system most of his academic life and demonstrated that, for certain time series with high volatility, a de-trend is recommended. He used the de-trend for the first time in his work titled Secular Movements in Production and Price. In this chapter the formula used to de-trend the time series is explained in Table 3.7. Moreover, a number of indexes have been analyzed using a 20-month simple moving average. A simple moving average is a statistical technique used to analyze a set of data points by creating an average of one subset of the full data set at a time with each number in the subset given an equal statistical weight. In this chapter, a 20-month simple moving average is used which means a 20-month simple moving average of closing price is the mean of the previous 20 months’ closing prices. If those prices are: PM, PM-1, PM-2, PM-3, …, PM-19, then the formula is SMA = {(PM + PM-1 + PM-2 + … + PM-19) / (20)}. Finally, each time a new data (month or period) is added to the time series, the entire moving average is recalculated to account for the new value added while dropping out the old one. Further, this 20-month moving average has been programmed and its exact formula is explained in Table 3.8. Table 3.8

20-month simple moving average

Inputs: Price(Close), Length(N); N = 20 Months; Plot1 = Current Value; Plot1[1] = Prior Value; Plot2[2] = Two Values Ago; Plot1(AverageFC(Price, Length), “SimpAvg1”); {Alert Criteria} IF Price < Plot1 AND Plot1 < Plot1[1] AND Plot1[1] > Plot1[2] Then Alert(“The Moving Average has just changed direction and is now uptrend”) Else If Price > Plot1 AND Plot1 > Plot1[1] AND Plot1[1] < Plot1[2] Then Alert(“The Moving Average has just changed direction and is now downtrend”);

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The Euro and the Foreign Exchange Market Graph 3.1 plots the US Dollar Index (USDX) from 1986 until December 2008. The USDX measures the performance of the US dollar against a basket of currencies composed of the euro (EUR), Japanese yen (JPY), UK pound (GBP), Canadian dollar (CAD), Swiss franc (CHF), and Swedish krona (SEK). This index started in March 1973, soon after the demise of the Bretton Woods System, and it is listed in the New York Board of Trade (NYBT).

Graph 3.1

US Dollar Index (USDX)

In 1995 the index value, worth around 80 (point A), began an appreciation period that lasted until 2002 when it reached a significant all-time high around 120 points (point B). Since 2002 the index has been steadily losing value, reaching at the beginning of 2008 an all-time low at around 72 points (point C). However, since 2008, the USDX has been gaining ground and has been testing new highs at around 90 (point D) but falling during most of 2009. It seems that the DJIA is recuperating again in 2010. Graph 3.2 plots the USDX with a 20-month simple moving average and the detrend of the index. The 20-month moving average crosses the USDX every time a change of tendency is taking place. This change of tendency is further represented by the “de-trend” of the index. When the index is changing tendency and is going up, the de-trend is in green. When the index changes tendency and is losing value, the de-trend is in red.

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Graph 3.2

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US Dollar Index with 20-month simple moving average and de-trended

Graph 3.3 plots the evolution of the US dollar against the deutsch mark (D-mark) from October 2009 to March 2010. The D-mark is no longer trading as a currency since it was absorbed by the euro. However, there are several foreign exchange data vendors who still maintain the daily trading value of European currencies such as the D-mark, French franc, Spanish peseta, and Italian lira. Technically speaking, the value of the US dollar divided by the value of the D-mark is known as the Dem—the name of the German currency in the foreign exchange market when it was traded against the US dollar. Graph 3.3 shows the evolution of the Dem from October 2009 to March 2010. Had the Dem not ceased to exist, its value

Graph 3.3

Deutsche mark composite

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over the past years would have been the one represented in Graph 3.3. In fact, its value as of March 9, 2010 would have been $1.4354/Dem. Graph 3.4 plots a positive relationship between the USDX and the Dem from October 2008 to March 2010. As the value of the USDX goes up, the value of the currencies that form the index goes down. Simultaneously, the evolution of the Dem shows that as the value of the US dollar goes up the value of the Dem goes down. Hence, when the USDX and the Dem exchange rates are plotted together, robust positive correlation is the result. The rationale behind this correlation is the following. An increase in value of the USDX represents the decrease in value of the currencies that form the index. For instance, from August to March 2010 the value of the USDX increased and the value of the currencies included in the index decreased. Simultaneously, the evolution of the Dem shows that from April to December 2009, the value of the US dollar decreased and the value of the Dem increased. Hence, there is an inverse relationship between the value of the USDX and Dem exchange rate; however, graphically they both move in tandem.

Graph 3.4

Deutsche mark composite and US Dollar Index

Graph 3.5 plots the evolution of the euro (€/$). Although the €/$ was first introduced on January 1, 1999, this graph represents a composite of the ecu/$ from 1979 to January 1, 1999 and the €/$ ever since. This graph shows how on January 1, 1999 the changeover from ecu/$ to €/$ took place above parity. On January 1, 2002, the common currency was physically introduced at a exchange rate under parity. However, since 2002 to mid-2008 the euro has been increasing in value, reaching an all-time high of around €1.5/$ during the third quarter of 2008 (point A).

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Graph 3.5

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Evolution of the euro

Graph 3.6 plots the evolution of the €/$ and the USDX since 1980. In this case, there is an inverse relationship between the USDX and the €/$. This perfect inverse relationship generates a curious mirror image effect. Hence, as the €/$ goes up the value of the USDX is going down. For instance, from 2002 to the middle of 2008 the value of the euro has been increasing against the US dollar and, at the same time, there is a decrease in the value of the USDX.

Graph 3.6

Euro and US Dollar Index

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Graph 3.7

Deutsche mark composite and euro

Graph 3.8

French franc and euro

Graph 3.7 plots the evolution of the €/$ and the Dem/$. Again, there is a perfect negative relationship between both currencies, generating (again) a mirror image effect. As the euro appreciates in value against the US dollar, the Dem is also gaining value against the US dollar. The reason for this relationship is that the Dem is part of the euro and if the euro increases in value, the Dem must also increase in value.

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Graph 3.9

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Spanish peseta and euro

Graph 3.10 Italian lira and euro The same can be inferred from Graph 3.8, which plots the relationship between the euro and the French franc (FRF). Although the FRF ceased to exist as a national currency with the introduction of the euro, the value of this currency has been continued by Future Source. If the FRF were to be reintroduced as a national currency in France, Graph 3.8 shows the evolution of its value from June 2003 until March 12, 2010. In fact, its value as of March 12, 2010, would have been $4.0106FRF. Since the FRF is part of the euro, there is a positive correlation in value; hence, as the value of the euro has been increasing against the US dollar, the value of the FRF has increased as well. Therefore, this relationship generates a mirror image effect. Graph 3.9 plots the €/$ and the $/Spanish peseta (ESP) and the same rationale applies. (Readers should note that the graph has been mislabeled by the data supplier: the data relates to the Spanish peseta, which in fact is identical to the Andorran

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peseta.) There is a positive correlation in value since as the euro appreciates against the US dollar the ESP does too. Graph 3.9 shows this relationship which generates a mirror image effect. Finally, Graph 3.10 plots the evolution of the Italian lira (ITL) from June 2003 until March 9, 2010. Once again, there is a mirror image effect between the evolution of the euro and the ITL. Graph 3.11 plots the evolution of the UK pound against the euro since January 2003. The GBP is not part of the euro and there is a vast debate on whether the GBP should, or should not, join the euro. Since mid-2008 the drop in value of the GBP against the euro has, once more, stirred the debate. When the euro was introduced in 1999, the value that the pound would have had against the euro was one of the reasons used to excuse the pound for not adopting the euro. On January 1, 1999 the value of the pound was very high against the euro, and joining would have meant a dramatic loss of purchasing power for those holding pounds. However, ever since January 1, 1999 the pound has been losing value against the euro. In fact, as of January 1, 2009 the value of the pound was close to parity with the euro. Curiously enough, it is now (early 2010), when the pound has almost reached parity with the euro, when the changeover would be monetarily beneficial for both parties.

Graph 3.11 UK pound and euro A detailed analysis of the evolution of the GBP and the euro can be found in Graph 3.12, which shows how since 2000 the pound has been moving with the euro but always with a higher value. Now, nonetheless, the fall of the pound is greater than the fall of the euro. Point A is very important because it marks the moment when the GBP had to leave the monetary snake, suffering a dramatic lost of value. Right after exiting the snake, the pound dropped to an all-time low level marked by point B; after that, it began to float freely against all currencies. Point C highlights the introduction of the euro and shows how the pound has been moving in tandem with the common currency. Finally, point D marks the second most important drop in the value of the GBP since 1992, a drop that has made the GBP to come closer to parity with the common currency.

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Graph 3.12 Euro and UK pound since 1981 In summary, Graphs 3.1 to 3.12 have brought out four interesting points. First, this chapter presents a number of European currencies that do not exist anymore; however, their trading values are still been published by Future Source. Second, a number of figures have proved that the euro is basically the continuation of the Dem, and that there is a perfect inverse relationship between the euro and the Dem against the USDX. Thirdly, Graphs 3.6 to 3.10 have shown that the euro, as well as all the currencies that form it, have been moving together, providing the euro with strength and stability. Finally, it can be concluded from the analysis that the euro has stabilized the value of the UK pound, bringing it in 2009 to a level which made, for the first time in history, jumping onboard the “euro boat” interesting for the UK. The Euro and the Stock and Commodities Markets This section focuses on how the euro has become a stabilizing factor for the Eurozone. In order to do so, it analyzes how the euro has helped smooth the business cycle by studying the correlations between the euro and both the Dow Jones Industrial Average (DJIA) and the German Deutscher Aktien IndeX 30 (DAX). Moreover, this section will demonstrate that the euro has helped contain inflation in the Eurozone.

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Graph 3.13 Dow Jones Industrial Average (DJIA) Graph 3.13 follows the evolution of the DJIA from 1989 to March 3, 2010. Since 1896 the DJIA has measured the daily performance of 30 of the largest “blue-chip” corporations in the US, making the DJIA the best-known measure of the performance of the stock market in the US. The DJIA is traded in the New York Stock Exchange (NYSE) in US dollars. In Graph 3.13, point A indicates that in mid-2007 the DJIA reached an all-time high at around 1,400 points after which it began to lose value to reach levels of around 7,500 points—levels tested in 2002 and 2004 (point B). However, since 2009 the DJIA has been rallying, which means that investors are back investing on the stock market.

Graph 3.14 DJIA with 30-month moving average and de-trended

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Graph 3.14 studies the DJIA when measured with an optimized 30-month moving average and the de-trend of the index. It shows that when the moving average crosses the index a change of tendency follows. This change of tendency is supported by the de-trend because every time the moving average crosses the DJIA, a change of tendency follows and the de-trend simultaneously changes. This graph demonstrates the validity of a 30-month moving average to forecast a change in tendency when plotted with the DJIA.

Graph 3.15 Deutscher Aktien IndeX 30 (DAX) Graph 3.15 graphs the evolution of the Deutscher Aktien IndeX 30 (DAX) from 1993 to March 10, 2010. The DAX is a market index representing the 30 major German companies trading on the Frankfurt Stock Exchange and is one of the most important stock indexes of the Eurozone. The value of the DAX was quoted in D-mark until December 31, 1999; since January 1, 2000 it has been expressed in euros. Graph 3.15 highlights that the DAX reached an all-time high of around 8,000 points in mid-2007 (point A); that is, right after the introduction of the euro. The DAX, however, has suffered an important loss of value when it sank to around 2,000 points at the beginning of 2003 (point B). Since then, the DAX has gained value, reaching a new high at around 8,000 points during 2007 (point C) just in time to begin a new decline (point D). The DAX can be considered a leading economic indicator for the Eurozone since, as point C shows, the DAX began to decline in the last quarter of 2007. However, the German government did not declare that Germany had entered a recessionary period until November 12, 2008; that is, almost one year after the DAX began to decline.

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Graph 3.16 DAX with 30-month moving average and de-trended

Graph 3.17 DJIA and US Dollar Index

Graph 3.18 DAX and euro

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Graph 3.19 DAX and euro Graph 3.16 plots the DAX against the optimized 30-month moving average. When the moving average crosses the DAX there is a change in tendency that is reflected in the “de-trend.” The values of the DJIA and USDX since 1992 are plotted in Graph 3.17, which shows that there is no clear relationship between the two; that is, from this graph it cannot be inferred that as the value of the USDX declines the value of the DJIA systematically increases or decreases. The relationship between the DAX and the euro is depicted in Graph 3.18. If Graph 3.17 showed no clear relationship between the DJIA and the USDX, Graph 3.18 plots a better relationship between the DAX and the euro. This shows that the strength of the ecu and the euro has helped the performance of the German index which, in turn, is a measure of stability.

Graph 3.20 DJIA and DAX with covariance

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Graph 3.21 DJIA, DAX, and Eurotop 100 Graph 3.19 depicts a clear positive relationship between both the DAX and the DJIA. This positive relationship between the two is further analyzed in Graph 3.20 by using an alternative way of presenting the traditional covariance. This graph plots a positive covariance between both indexes which hints that the euro has helped harmonize and stabilize the business cycle on both sides of the Atlantic. However, data on the DAX traded in euros has only been available since 1998, offering a very short time series of only ten years. Moreover, since the covariance is based on 30 months, the result of the covariance is limited although robust. Graph 3.20 plots a positive covariance between both indexes which again hints that the euro has helped harmonize and stabilize the business cycle on both sides of the Atlantic. However, data on the DAX traded in euros has only been available since 1998, offering a very short time series of only ten years and again, since the covariance is based on 30 months, the result of the covariance is limited although robust. Finally, Graph 3.21 plots the evolution of the DJIA, the DAX, and the Eurotop 100 indexes showing that all of them are moving in unison although the euro and the US dollar are moving in opposite directions. The next group of graphs helps us to conclude that the euro has harmonized and stabilized prices in the Eurozone. Graph 3.22 plots the evolution of the Crude Oil (CO) and the CRB Indexes. In the US, the curve of the CO Index is the price— in US dollars—of the light sweet crude oil future contract traded on the NYSE which represents the cost of imported crude oil. The CRB Index curve is a worldrenowned index comprised of 28 commodities that serves as the most widely recognized measure of global commodities prices which, in turn, are “responsible” for consumer prices, and, ultimately, inflation rates. Hence, the price of the CO and CRB are two key indexes for measuring and forecasting inflation rates worldwide. Graph 3.22 shows that since 2007 both

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Graph 3.22 Crude Oil and CRB Indexes indexes have suffered an increase in price reaching all times highs during the summer months of 2008. Fortunately, since mid-2008 both indexes are experiencing a decrease in their prices which has helped alleviate not only inflation pressure worldwide but also economic prospects. In fact, Graph 3.23 shows that there is a strong covariance between these two indexes: as the price of oil increases so does the price of commodities.

Graph 3.23 CRB and Crude Oil Indexes with covariance

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Graph 3.24 CRB Index and US Dollar Index This second set of graphs has demonstrated that there has been a systematic increase in the overall prices of both commodities since 2003. Both commodities are quoted in US dollars, and Graphs 3.24 to 3.27 demonstrate that the increase in the prices of crude oil and commodities have had a direct impact on the economies of the US and the Eurozone. Graph 3.24 plots the relationship between the US Dollar Index and the CRB Index. Curiously, as the CRB Index increases in value the value of the USDX is decreasing. This inverse relationship explains that the US has been suffering from the increase in price of these two important resources; in fact, the US has

Graph 3.25 Crude Oil and US Dollar Indexes

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been paying the rising prices with a weak dollar, which has negatively affected its economy. Graph 3.24 shows that from June 2003 to June 2008 the USDX was losing value while the CRB Index was increasing. After June 2008, however, the CRB Index began a steep decline and the USDX timidly began to gain ground. This inverse relationship between the CRB and the US dollar has been a devastating factor for the economy of the US in 2009. The same can be appreciated in Graph 3.25, which demonstrates that in June 2008, when the price of oil reached record highs, the USDX was exhibiting record lows. At this point, a gallon of gasoline reached an all-time high in the US, affecting considerably not only productivity and industrial growth as it became extremely expensive to pay the bill, but also having a negative effect on inflation as prices of goods and services had to be adjusted to account for the increase in the price of crude oil.

Graph 3.26 Crude Oil and US Dollar Indexes with covariance For instance, the relationship between the USDX and the price of crude oil (CO) is depicted in Graph 3.26, which plots the covariance between the two indexes and shows that there is a negative covariance between them; that is, as the price of CO was increasing, the value of the USDX was decreasing. In fact, the negative covariance is more significant—it reaches more than –0.60 of correlation—from January 2008 to November 2009 when the price of oil was going up dramatically and the value of the USDX was going down. Finally, as Graph 3.23 demonstrated that there is a strong covariance between crude oil and the CRB, it is safe to imply and conclude that if there is a strong negative covariance between the USDX and the price of crude oil, there is a strong negative relationship between the USDX and the CRB as well. Fortunately the Eurozone has not suffered this toll and Graph 3.27 plots that as the price of CO has been increasing since June 2003 so has the value of the

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Graph 3.27 Crude Oil Index and euro common currency. This means that the Eurozone has had an advantage when paying its oil bills because, although the Eurozone Member States had to pay the price of crude oil in US dollars, the value of the euro against the US dollar has been very favorable for these countries. This has been an advantage for all Eurozone Member States, particularly between 2003 (when the price of crude oil increased from around US$50) and mid-2008 (when the price reached historic highs of around US$150). In fact, from March to August 2008 the price of oil fluctuated between US$120 and US$150 and the value of the euro reached historic highs at around €1.50/$. As of March 2010, the price of crude oil was US$81.52 while the euro was quoted at US$1.36. This section has therefore shown that the euro has been a major stabilizing factor for two reasons. First, the euro has harmonized the business cycle by bringing together stock indexes prices which are considered leading economic indicators. Second, the strong euro has helped pay the high prices of crude oil and commodities in the Eurozone which, in turn, has helped keep inflation under control. The Euro and the Money Market This section analyzes Graphs 3.28 to 3.34 to study the relationship between the euro and the money market (MM). The MM is a subsector of the fixed-income market and consists of very short-term debt securities that usually are highly marketable.

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The purpose of this section is twofold. On the one hand, it tries to demonstrate if there is a synchronization of the monetary cycles in the US, the UK and the Eurozone since the introduction of the euro. On the other hand, it analyzes the effect of the euro in the money market in the Eurozone. The aim of this section is to study the behavior of the European Central Bank in its mission to use monetary policy to control prices and its impact, if any, in the euro. Analyzing, therefore, the MM is important because the ECB uses the MM as escape valve to fight inflation and to maintain price stability. In theory, it is expected that whatever decision the ECB takes to fight inflation and maintain stability will, in turn, affect the value of the euro.

Graph 3.28 US 2-year Treasury Note and Eurodollar (3 months) Graph 3.28 plots both the US 2-year Treasury Note (T-Note) and the Eurodollar. The Eurodollar is the name given to all the dollar-denominated deposits at foreign banks, or foreign branches, of American banks. Despite the tag “euro,” these deposits are not in euros. Most Eurodollar deposits are for large sums with less than six months’ maturity. Based on these deposits, the Eurodollar futures contracts are futures contracts traded at the Chicago Mercantile Exchange (CME) in Chicago. The US 2-year T-Note is a US government debt financing instrument issued by the US Department of the Treasury. Graph 3.28 shows that both indexes move in unison and that there is a close correlation between the T-Note and the Eurodollar deposits. The reason for this is that as the price of the T-Note is increasing the discount yield paid to hold this security is decreasing; as a consequence, demand for the T-Note is decreasing, which seems to affect directly the demand for Eurodollar future contracts. Graph 3.29 explains the relationship between the US T-Note (10-years) and the German Bund. The US 10-years T-Note has become the security most frequently used when analyzing the performance of the US government bond market and one of the most used instruments to convey the market’s take on longterm macroeconomic expectations in the US. The German Bund is the name of Germany’s federal bond issued by the German government to finance spending. It is, therefore, a government-backed instrument of the highest quality, as is the T-Note. Graph 3.29 plots the positive relationship that has always existed between

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Graph 3.29 US 10-year Treasury Note and Bund both securities as they share the same trend; this similarity in trend can be explained because both the Federal Reserve and the Bundesbank were implementing the same type of monetary policy; there is therefore a synchronization of the business cycles. However, since the introduction of the euro in 1999, there has been an impressive perfect match between the two. Therefore, it is fair to assert that from 1999 to 2010 there has been harmonization in the debt market on both sides of the Atlantic. Only from 2004 to 2008 has there not been a perfect match, although the trend has been the same. Therefore, it is safe to assert that since the introduction of the euro these two treasury securities have witnessed an increase in their synchronization.

Graph 3.30 Eurodollar (1 month) and Eurodollar (3 months)

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Graph 3.31 EURIBOR (3 months) and Eurodollar (3 months) Graph 3.30 plots the 1-month Eurodollar and the Eurodollar 3-months, demonstrating a close relationship between the two and proving a close relationship between the US and the European business cycles. However, Graph 3.31 plots a lack of relationship between the EURIBOR 3months and the Eurodollar. EURIBOR stands for the Euro Interbank Offered Rate, and it is the average interest rate at which term deposits are offered between prime banks in the Eurozone money market. The EURIBOR is used as the reference rate for euro-denominated short-term interest rates. The relationship, or lack thereof, between these two indexes is represented in Graph 3.31. This is a very significant graph as it conveys important information on the performance of the European Central Bank (ECB) and the US’s Federal Reserve. The Eurodollar began a clear downtrend in June 2004 demonstrating that monetary authorities in the US were already changing the monetary policy. However, the EURIBOR did not begin to decrease until 2006. This means that it took the ECB approximately one year to reduce rates. Further, this graph shows how the Eurodollar was stable for almost a year (from June 2006 to June 2007) before it saw an increase again in the third quarter of 2007. The Eurodollar has been erratic since then. However, the Eurozone is lacking this transition period as the EURIBOR has been in a downward trend since the end of 2005 to December 2008, and since 2008 it has been suffering an erratic path. All this shows that while the American index is a leading economic indicator, the EURIBOR is not. There is also an interesting relationship between the EURIBOR 3-months and the London Interbank Offered Rate (LIBOR). The LIBOR is the interest rate at which banks borrow funds from other banks in the London interbank market. This rate, which is quoted in dollar-denominated loans, has become the premier short-term interest rate quoted in the European money markets, and it serves as a reference rate for a wide range of transactions. Hence, the LIBOR has become one

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of the most important interest rate benchmarks because it is the rate at which most preferred borrowers can borrow money and the one used to make adjustments to adjustable rate mortgages. Graph 3.32 plots the relationship between the LIBOR and the EURIBOR. Curiously, this graph very much resembles Graph 3.31; in fact, analyzing Graphs 3.31 and 3.32 helps us to conclude that the LIBOR and the Eurodollar enjoy a high correlation. The LIBOR began to decrease at the beginning of 2004 just when the Eurodollar was decreasing as well: the LIBOR enjoyed a period of stability from June 2006 to July 2007 as well as the Eurodollar, but has been erratic ever since. This brings the conclusion that the Fed and the Bank of England do have the same cycle; however, the ECB follows them with a year’s delay. This is interesting as it demonstrates that the ECB is faithful to its commitment to price stability.

Graph 3.32 EURIBOR (3 months) and LIBOR (1 month) Graphs 3.28 to 3.32 have demonstrated that there is a harmonization of the monetary policies and money markets of the US, the UK, and the Eurozone, which indicates that there has been an improvement in the synchronization of the business cycles. However, while the US and UK have an identical business cycle trend, the Eurozone follows behind, indicating that the Eurozone business cycle has merged but is not yet fully synchronized. Graphs 3.33 and 3.34 shed light on the relationship between the euro and the EURIBOR and the Bund. The theory goes that as the EURIBOR increases, the euro should see an increase in value. Similarly, if the EURIBOR and the euro increase, the German Bund should see an decrease in its price. Graph 3.33 shows how in 2006 the ECB began to decrease the EURIBOR, affecting the price of money. Against all expectations, as the EURIBOR was declining, the value of the euro was increasing. These two economic circumstances can be identified with a boost in inflation in major Eurozone Member States in the past two years. However, the graph also points out that as interest rates began to be raised in summer 2008, the value of the euro began to decline. Moreover, Graph 3.34 plots the relationship between the German Bund and the euro since June 2004. This graph is somewhat controversial as it contradicts

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Graph 3.33 EURIBOR (3 months) and euro economic and monetary theory. According to the theory, there should be a direct relationship between the German Bund and the euro. As the yield paid by the Bund increases, the demand for the euro should increase accordingly. However, Graph 3.34 demonstrates that there is “carry-trade” with the euro.

Graph 3.34 Euro and Bund Final Words From a qualitative standpoint, this chapter demonstrates that the euro has become a solid common currency, and a monetary and economic stabilizer. From a quantitative standpoint the euro has in fact become a stabilizing factor for the Eurozone and the EU as a bloc. As a consequence, the euro has become a successful common currency for the Eurozone. This statement is corroborated by the analysis of the euro in three important markets. The first section—“The Euro and the Foreign

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Exchange Market”—quantitatively confirms that the euro has become a solid common currency by examining the relationship between the US Dollar Index (USDX) and the D-mark to explain the creation of the euro. Further, the evolution of the Spanish peseta, the Italian lira, and the French franc showed that, if those currencies were today in circulation they would be following the euro cycle. These quantitative results prove that the euro has become a de facto common currency for Eurozone Member States. Also, this section explains the relationship between the UK pound and the euro and emphasizes that since early 2008 both currencies have been moving in tandem (and there has been a synergy in both currency cycles hinting at a possible long-time desired merger between the pound and the euro). The second section—“The Euro and Stock and Commodities Markets”—provides a thorough view of the behavior of the euro in compliance with the monetary policy requirements imposed by the Maastricht Treaty. To do this, this section first presents how the stock markets have reacted to the introduction of the euro. It further shows that there is a lack of relationship between the valuation of the Dow Jones Industrial Average (DJIA) and the German DAX, and between the USDX and the euro. However, the data proves that since the introduction of the euro, the DJIA, the DAX, and the Eurotop 100 have been increasingly correlated. Moreover, this section presents data that supports the idea that the euro has helped maintain prices under control since 2007 when the value of both the CRB and the CO reached all-time record highs; in fact, these high prices were balanced out by the euro reaching record highs. Since 2007, the appreciation of the euro has helped offset the rise in commodity prices, especially oil. Therefore, the euro has so far helped maintain prices and inflation under control. The final section—“The Euro and the Money Market”—specifically presents a detailed analysis of the euro money markets, which are influenced by the ECB’s setting of interest rates to control prices and inflation. This section presents the relationship between the euro and the EURIBOR, compared with the behavior of the USDX, the US T-Note, and the LIBOR. The statistical results demonstrate that the LIBOR and the US T-Note money market cycle moved in unison until the euro was introduced. With the introduction of the euro, the LIBOR, particularly during 2009, has been converging with the EURIBOR. This proves that the euro has also acted as a stabilizer for the money market but that the business cycle in the Eurozone lags behind. As in most scholarly works, this study has its own specific limitations. One such limitation concerns the quality and variety of the economic and monetary time series available to study the economy of the Eurozone and its Member States. The quality of the data found was at times weak for two reasons. First of all, the Eurozone was formally created on January 1, 1999; hence, most time series just cover the Eurozone from 1995. This means that most economic and monetary time series just provide 14 years of information. The length of these series is in some cases not enough to apply a variety of relevant statistical methods which require a larger number of periods in order to eliminate “statistical noise.”

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There is, moreover, a very limited variety of time series available to study economic, monetary, fiscal, and social issues in the Eurozone. This study has, in fact, been limited at times by the difficulty in comparing a number of time series that would have helped infer a stronger conclusion. Had some of these indexes been available for the Eurozone, they would have warned of the situation that has unfolded in certain countries which have been greatly affected by the demise of their construction/real estate markets. This study has therefore been limited by the availability of the data and not by the tools necessary to analyze and interpret the data. In fact, the value-added of this work rests on the use of sophisticated computer programs used to transform the numerical data and to apply innovative statistical methods to infer conclusions. This study has demonstrated that the use of optimized statistics methods, such as moving averages, covariances, and detrending, to study a series of graphs and indexes could be of great help to “predict” the trend of some time series. Although these statistical methods have helped find repetitive patterns in this particular time series, there is no guarantee that these repetitive patterns could be found in every single one. In conclusion, had all the data necessary been available for the Eurozone, stronger statistical conclusions could have been reached on whether the euro has been a monetary, economic, fiscal, and social stabilizer for the Eurozone. Accurate and lengthy time series are powerful academic tools that arm any scholar with a competitive advantage to produce significant results. In fact, the superiority and importance of the US’s reports is based on the strength and accuracy of the data used. The US has a structured system of well-defined time series organized by leading, coincident, and lagging economic indicators. Researchers using these tools are able, without a doubt, to come up with powerful conclusions about the state of the US economy and even to elaborate on its future. The Eurozone that is “under construction” must understand the importance of having an organized and reliable set of harmonized data in order to facilitate robust and accurate research.

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Chapter 4

The Euro as an International and Global Currency The creation of the European Monetary Union (EMU) and the introduction of the euro brought about an intense debate concerning whether or not the euro would manage to challenge the status of the US dollar and the hegemonic power of the United States as consolidated since World War II. For this challenge, the euro had to first consolidate its position as a common currency, then gain recognition as an international currency and, finally, become a global, or dominant, currency. As the euro gained international financial recognition, it became a stabilizing tool capable of furthering the political integration process of the European Union (EU). The euro has provided the economies of Europe with a degree of collective macroeconomic stability, flexibility, and economic transparency that individual Member States could never have achieved on their own. Therefore, the effect of the euro has not only been economically but also politically significant since its inception as an international currency with enough weight to garner, for Europe, some of the political influences heretofore enjoyed solely by the US due to the hegemony of the dollar since World War II. This chapter examines whether or not it can be claimed that the euro has become an international and global currency. The results show that the euro has developed a solid market that has consequently eroded some of the advantages that historically supported the hegemony of the US dollar as a global, or dominant, currency. Hence, the euro can be considered an international currency; nevertheless, the US dollar remains the sole global currency. There are two correlated reasons that explain the reign of the US dollar. On the one hand, there is the inertia in the use of the US dollar due to years of currency preeminence. On the other hand, this preeminence has given the greenback an edge over the euro in terms of the size, credit quality, and liquidity of the dollar financial market over the euro financial market. The preeminence of the US dollar has helped the US become a political hegemony, which has resulted in the “Pax Americana.” The euro has, nonetheless, transformed the Eurozone into a solid and internationally respected economic bloc with a wide area of influence and with an ever-increasing voice in the political and economic arena. However, these achievements have oftentimes been the target of fear and confusion expressed by public opinion and representing the perspective of the euroskeptics. Nevertheless, the reality is that the Eurozone has become viably competitive with the US for the first time in history. This chapter will briefly review the history of the euro and how it has become an international and global currency.

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The Euro and its Evolution: From Common Currency to International Currency The euro was nominally introduced on January 1, 1999 and despite its success as a common currency, the full impact of the euro is yet to be seen at the time of writing (early 2010). Nonetheless, with the available data, it is not too bold to affirm that the euro has contributed to integration on many levels. Indeed, ever since the introduction of the euro, Eurozone Member States have experienced an increase in trade. The euro has not only reduced both direct and indirect trading costs but has also removed the exchange risk and the cost of currency hedge. The euro has allowed for price transparency, and reduced price discrimination. Finally, the euro has reduced competitive devaluations, which have helped bolster foreign direct investments. The euro has therefore brought countries together; as Trichet (2006, 4) indicates, “we are not witnessing the creation of a ‘fortress Europe,’ but that the European Integration is perfectly complementary with the global integration.” The euro is, above all, money. In economic theory, money refers to the circulating currencies with legal tender status conferred by a national state and government. In order for a currency to be considered “money” by a nation’s government it has to serve as a unit of account, a store of value, and a medium of exchange. Furthermore, a limited number of national currencies can be considered to be an international currency, or currency that plays an active role in both international trade and financial transactions. Mundell (1999, 4) explains that a currency is international “when it is used outside the domain in which it is legal tender.” National governments do not decide which currency will become international; rather, it is decided, indirectly, by the market which examines the size of the economy and financial system and analyzes the currency’s value as well as the level of political stability of the country. Hence, not all national currencies can become international. Francesc Granell (2007, 205) explains that “the size of the market, the exchange restrictions and the aforementioned inertia/tradition” are key in determining if a currency can be used as an international currency. However, most governments work hard to transform their national currency into an international one as it helps a country strengthen its international political position. Benjamin Cohen (2007, 104) explains that there are four benefits to becoming an international currency: a potential for seigniorage (the implicit transfer of resources, equivalent to subsidized or interest-free loans, that go to the issuer of money that is used and held abroad): (2) an increased flexibility in macroeconomic policy afforded by the privilege of being able to rely on one’s own currency to help finance foreign deficits; (3) a gain in status and prestige that accompanies market dominance, a form of “soft” power; and (4) a gain in influence derived from the monetary dependence of others, a form of “hard” power.

The Euro as an International and Global Currency

Table 4.1

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Functions of an international currency

Function Unit of account Store of value Medium of exchange

SECTOR Private Invoice Financial assets Vehicle/substitution

Official Exchange rate peg Reserves Intervention

Table 4.1 outlines the three major functions that all currencies must fulfill in order to become an international currency (Pollard 2001, 18). Trichet (2006, 2) explains that soon after its introduction, the euro not only succeeded in becoming an international currency but also demonstrated that “one single currency is more efficient than multiple currencies in performing the roles of a medium of exchange and unit of account.” On August 1, 2007, Diana Farrell (2008, 2) reported that “there were $840 billion worth of euro notes sloshing around the world, compared to $814 billion US dollars.” Jean-Claude Trichet explains that the European Central Bank (ECB) estimated that “the stock held outside the Eurozone must be worth at least €55bn, and that it is almost certainly too low an estimate given the net outflow accounted for by tourists.” This chapter analyzes the function of the euro as a unit of account and as a store of value. The Euro as a Unit of Account: Invoice Currency and Currency Peg A currency will be considered an international currency if it can operate as a unit of account at both the private and the official level. In the private sector, the euro must be used to price international trade and debt contracts; that is, it must be used as an invoice currency. In theory, when trade takes place between two industrial economies, the invoice will have the currency of the exporter. Trade between industrial and developing countries will be invoiced in the currency of the industrial country. Trade between two developing countries is usually priced in the currency of a third country. The data shows that before the euro was introduced, the US dollar was the designated third country leading currency. The preeminence of the US dollar continues to this day; however, its potency has diminished with the introduction of the euro. Jeffrey A. Frankel (2008) asserts that countries in the Eurozone have experienced a significant increase in their bilateral trade with other Eurozone member states. He notes that this general trend has also been corroborated by the findings of other scholars. In fact, Frankel (2008, 3) explicates Flam and Nordström (2006) found an effect of 26 percent in the change from 1995–98 to 2002–05. Berger and Nitsch (2005) and De Nardis and Vicarelly (2003) reported similarly positive results. More recently, Chintrakarn (2008)

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finds that two countries sharing the euro have experienced a boost in bilateral trade between 9 and 14 percent. Overall, the central tendency of these estimates seems to be an effect in the first few years on the order of 10–15 percent.

Graph 4.1 shows the evolution of export activity between Eurozone Member States. It clearly demonstrates that trade among Eurozone Member States has increased, especially after 2001.

Graph 4.1

Export activity between Eurozone’s Member States

Source: Bloomberg Finance LP

In the official sector, the euro is considered to be a unit of account dependent on the number of countries that choose it as a currency peg. Under the Bretton Woods System most currencies were pegged to the US dollar. When the Bretton Woods System collapsed, some of the currencies allowed their value to float, but most chose to peg their exchange rates to the US dollar. Although, there was a general preference for the US dollar, some European currencies began to develop areas of interest. This was the case with the French franc that was used as a currency peg for most of France’s old African colonies. This was also the case for the UK pound, which was used as the currency peg for most of its old colonies, mainly those located in the Caribbean. The Euro as a Store of Value: Financial Assets and Reserve Currency Currencies act as a store of value when they guarantee the purchasing power of money over time. Granell (2007, 206) clarifies that: the future trends in this international function of the euro as a “store of value” would depend on the “euro intrinsic” qualities demonstrated to the markets, and

The Euro as an International and Global Currency

Table 4.2

Some currencies pegged to the US dollar, the euro, the UK pound, and other currencies

Pegged to the:

Currency

Pegged rate

US dollar

Bahamian dollar Belize dollar Bermudian dollar Cayman Island dollar Cuban convertible peso East Caribbean dollar Eritrean nakfa Lebanese pound Maldivian rufiyaa Panamanian balboa Qatar riyal Venezuela bolivar Bulgarian lev Bosnia/Herzegovina convertible mark CFA franc Comorian franc (Comoro) Danish krone Estonian kroon Latvian lat Lithuanian litas Gibraltar pound Guernsey pound Jersey pound Manx pound (Isle of Man) Cook Island dollar Kiribati dollar (Kiribati) Lesotho loti Swazi lilangeru (Swaziland) Nepalese rupee Tuvaluan dollar (Tuvalu) Abkhazian apsea (Abkhazia) Belarusian ruble

Par 1 US$ to 2 BZ$ Par 1 KYD to 1.2 US$ 1 Cuban peso to 1.08 US$ 1 US$ to XCD 5.40 1 US$ to 16.5 nakfa 1 US$ to 1,507.5 pound 1 US$ to 12.8 rufiyaa Par 1 US$ to 3.75 riyals 1 US$ to 4,299 bolivars 1 € to 1.95 leva 1 € to 1.95 marks (BAM) 1 € to 665.95 CFA francs 1 € to 491.96 KMF francs 1 € to 7.46 kroner 1 € to 15.64 krooni 1 € to 0.702 lats 1 € to 3,452 litas

Euro

UK pound

Others

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Par Par Par Variant New Zealand dollar at par Australian dollar at par South African rand at par South African rand at par Indian rupee to 1.6 NR Australian dollar at par Russian rouble to 0.10 apsea Basket of currencies (which include the euro, the Russian ruble, and the US dollar)

the political will of the national authorities of the third countries to diversify the euro to avoid overdependence on the US dollar if the United States continues to run enormous external imbalances.

In the private sector, the purchasing power of the euro is measured by the demand of products denominated in euros in the bond market, money market, and foreign exchange market for currency diversification.

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For instance, since the introduction of the euro in 1999 the bond market has witnessed two developments. On the one hand, there has been an increased trend in total euro-denominated bond issuance, and, on the other hand, there has been an increase in the number of bonds issued by the Eurozone Member States. According to Cappiello et al. (2006) this demonstrates that after the introduction of the euro, the bond market has witnessed a dramatic increase in integration, proving that the single currency has been an integrating factor. First of all, the total euro-denominated bond issuance has been growing consistently since 1999. Graph 4.2 demonstrates that the total volume of bonds issued in euros has tripled between 1999 to 2009. However, it is important to analyze the evolution of debt issuing by governments as well as by corporations and financial institutions. While the issuing evolution of both types of bonds are important to measure how the euro has become an instrument to store value, the increase in debt issued by corporations and financial institutions demonstrates that the euro has broadened access to the capital market.

Graph 4.2

Total bond issuing activity in Eurozone

Source: Bond Market Notes, European Commission’s Directorate of Economic and Financial Affairs