Eurozone: Currency Union, Economy & Impact (Benefits, Drawbacks, How It Works)

What’s it: The Eurozone is an area of ​​the European Union (EU) that adopts the Euro as its official currency. Of the 28 EU members, nineteen of them adopted the Euro as their currency, namely France, Germany, Austria, Belgium, Cyprus, Estonia, Finland, Greece, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Portugal, Slovakia, Slovenia, and Spain.

The Eurozone has become one of the largest economic regions in the world. The following is the size of the economy of each member country based on the gross domestic product (in billion US$)

Eurozone as a monetary union

The Eurozone represents a significant step forward in economic integration, functioning as a monetary union established within the European Union (EU). It builds upon the foundation of the EU’s common market, which already guarantees the free movement of goods, services, and capital. The key addition in a monetary union is the adoption of a single currency managed by a central governing body.

Here’s a breakdown of the different stages of economic integration, culminating in a monetary union like the Eurozone:

• Preferential Trade Area: This initial step involves member countries reducing, but not eliminating, trade barriers like tariffs on specific goods.
• Free Trade Area: Trade barriers are entirely eliminated, allowing for the free flow of goods and services between member countries. However, individual countries retain the flexibility to set their own trade policies with non-members.
• Customs Union: A free trade area is combined with a uniform trade policy for trade with non-member countries. This means member countries agree on common tariffs and quotas for imports and exports from nations outside the union.
• Common Market: This stage builds upon a customs union by allowing for the free movement of factors of production, such as labor and capital, in addition to goods and services. Imagine skilled workers being able to find jobs freely across member countries or businesses being able to invest capital wherever they see the best opportunities.
• Economic Union: A common market is further enhanced by establishing common economic policies and forming joint institutions for economic cooperation. This stage signifies a deeper level of economic integration among member countries.
• Monetary Union (The Eurozone): The final stage of economic integration involves the adoption of a single currency managed by a central bank. This eliminates exchange rate fluctuations between member countries and fosters a more stable economic environment within the union. The Eurozone, with the Euro as its shared currency, serves as a prime example of a monetary union.

Member Countries: working together for economic stability

Member countries within the Eurozone aren’t just adopting a common currency – they’re actively working together to achieve shared economic goals. This collaboration focuses on achieving sustainable economic growth, which translates to a healthy business environment and better job opportunities for citizens across the Eurozone.

Here’s a closer look at how economic policy coordination functions:

• Fiscal policy: Member countries strive for fiscal discipline, which essentially means responsible budgeting and managing government debt. The Stability and Growth Pact (SGP) acts as a set of guidelines, encouraging members to keep their budget deficits below 3% of GDP (Gross Domestic Product) and national debt under 60% of GDP. This helps maintain financial stability within the union.
• Monetary policy: The European Central Bank (ECB) takes the reins on monetary policy for the entire Eurozone. Chaired by a president and a board representing each member country’s central bank, the ECB prioritizes maintaining price stability. This translates to keeping inflation – the rate at which prices for goods and services increase – under control. As of November 2020, the ECB targets an inflation rate of around 2%. Price stability protects consumers from the negative effects of inflation, like a constant rise in the cost of living.
• Single market operations and financial supervision: Effective coordination also extends to ensuring the smooth functioning of the single market and supervising financial institutions throughout the Eurozone. This fosters a more predictable and secure economic environment for businesses and investors.

National control vs. Shared responsibility

While member countries collaborate on these economic fronts, they retain control over certain areas:

• Government budget: National governments still have the authority to set their own budgets, though they are mindful of the SGP guidelines.
• Taxation: Tax policies remain largely within the control of individual member states.
• Social programs: National governments continue to manage their own pension systems and labor regulations.
• Financial markets: Regulations for capital markets, which involve the buying and selling of investments, are primarily determined by national governments.

This balance between national control and shared responsibility allows member countries to tailor certain policies to their specific needs while cooperating for the overall economic health of the Eurozone. In the wake of the 2008 global financial crisis, the Eurozone implemented additional measures, including emergency loan provisions for member countries facing economic hardship. This highlighted the union’s commitment to mutual support during challenging times.

Advantages of establishing the Eurozone

First, the Euro has become one of the dominant currencies in the world. Due to its broader use in member countries, the credibility of the Euro increases. The Euro has become one of the main currencies of foreign reserves. Citing the International Monetary Fund (IMF) report, around 20.54% of global currency reserves use the Euro, the second-highest after the United States dollar.

Second, transaction costs and currency hedging are low because the currency is more stable. As a result of the single currency, nominal exchange rates’ volatility and uncertainty are much lower.

Third, trade and capital transaction costs fall. Since the Euro serves as a currency in international trade, the transaction costs of residents in the Euro area also decrease. Likewise, for investment flows between member countries, investors can lend money to companies in other eurozone countries without bearing currency risk.

Fourth, the allocation of resources is more efficient. The integration allows the flow of goods, services, labor, and capital to increase in the euro-area countries. The market will lead them to their most productive use.

Fifth, broader market access and increased competition. Integration results in market expansion and increased competition. Domestic companies can sell goods and services freely to other member countries without having to face trade barriers.

Likewise, the free flow of capital makes it easier for them to invest in other member countries. This facilitates and promotes growth for less affluent countries such as Spain, Greece, and Portugal.

Competition between companies increases. They not only compete with local competitors but also competitors from other member countries. That, in turn, promotes greater price transparency, prevents price discrimination and monopoly power, and increases innovation and efficiency in the economy.

Sixth, interest rates are decreasing. Countries with a tradition of high public debt and inflation (such as Italy) can benefit from this. In addition to benefiting from currency stability, they must apply high discipline in monetary and fiscal policy.

Downsides of establishing the Eurozone

First, integration has no significant effect on spurring growth. For example, the German economy slowed down quite seriously and even contracted during the second quarter of 2019. Since the 2008 crisis, economic growth in the Euro Area has been less than 3%.

Second, member countries lost their independent monetary policies. Economic policy is for a common goal. However, it may not be a good recipe for individual economies. For example, they cannot make interest rate adjustments to affect their respective economies.

Third, economic shocks in one member spread rapidly to other members. This endangers the Euro Area and the world, considering its significance in the global economy. To overcome it, substantial economic costs will be required, as happened during the region’s debt crisis.

Not only internal shocks but external shocks are also nasty for this region. Its economic costs can be highly expensive because it exposes all member countries. For example, due to the 2008 financial crisis, the European Commission issued a fiscal stimulus package worth €200 billion.

Likewise, the COVID-19 pandemic forces fiscal authorities to inject liquidity equivalent to around 20% of the euro area’s GDP. In numbers, the ECB launched a pandemic emergency purchase program (PEPP) worth €1.35 trillion.