Table of Contents
- Eurozone as a monetary union
- How the Eurozone works
- Advantages of establishing the Eurozone
- Downsides of establishing the Eurozone
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.
Eurozone becomes 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$)
|Euro area (19 countries)||15,634,133||16,185,051||16,899,489|
Eurozone as a monetary union
The Eurozone is an example of a monetary union. It is the final stage of economic integration after the economic union. In order, economic integration involves the following stages:
- Preferential trade area – reduction (not eliminating) trade barriers such as tariffs, usually for some goods.
- Free trade area – free flow of goods and services between members through the elimination of trade barriers. However, members are still flexible to set different policies for trade with non-member countries.
- Customs union – free trade areas + uniform policy for trade with non-members.
- Common market – customs union + free flow of factors of production between member countries.
- Economic union – common markets + common economic policies + formation of joint institutions.
- Monetary union – economic union + the adoption of a single currency.
In summary, the characteristics of a monetary union are:
- The use of the single currency as the official currency
- Adopt common economic policies
- Establishment of joint institutions to coordinate economic and monetary policy.
- Free flow of goods, services, and factors of production (such as capital and labor)
- Uniform policy for trade with non-member countries
How the Eurozone works
Member countries coordinate economic policies to achieve sustainable economic growth rates and high employment opportunities. The scope of economic coordination includes fiscal, monetary, single market operations, and supervision of financial institutions.
Meanwhile, the national governments of member countries still have control over elements such as:
- Government budget
- Pension system
- Labor regulations
- Capital market regulations
In fiscal management, the Stability and Growth Pact (SGP) requires fiscal discipline among members. That requires a fiscal deficit of less than 3% of GDP and a fiscal debt of less than 60% of GDP.
To coordinate monetary policy, the Eurozone established the Eurosystem, which consists of the European Central Bank (ECB) and the member countries’ central banks. The monetary authority’s main objective is to maintain price stability, maintain financial stability, and promote financial integration.
The ECB is chaired by a president and a board, consisting of the member countries’ central banks’ heads. The ECB’s main objective is to keep the inflation rate in the Eurozone. As of November 10, 2020, the target inflation rate is around 2%.
In the context of economic reforms after the 2008 global financial crisis, the Eurozone set provisions to provide loans to member countries in emergency times.
Advantages of establishing the Eurozone
First, the Euro becomes 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 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, they can invest in other member countries more easily because of the free flow of capital. It 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 will require substantial economic costs, 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.