Currency Unions and the Eurozone (AQA A-Level Economics): Revision Notes

Currency Unions and the Eurozone

What is a currency union?

A currency union is an agreement between a group of countries to share a common currency and typically to implement a single monetary and foreign exchange rate policy. Currency unions are sometimes referred to as monetary unions.

The United Kingdom provides a familiar example. Although the UK consists of England, Scotland, Wales and Northern Ireland, all these nations use the pound sterling as their common currency. Similarly, the 50 states of the United States, plus the federal district of Washington DC, all use the US dollar. Both examples demonstrate how a currency union brings together multiple regions or countries under one shared currency system.

The euro and the eurozone

Creation and introduction of the euro

The euro officially came into existence on 1 January 2002, when euro notes and coins entered circulation. However, economists typically date the euro's introduction as 1 January 1999. This earlier date marks when the exchange rates of the 12 countries that became the first members of the eurozone (or euro area) were permanently fixed against each other.

The development of the euro began in the early 1990s with the Treaty of the European Union (also known as the Maastricht Treaty). This treaty initiated the process that eventually led to the creation of a monetary union within the eurozone.

Why was the euro created?

At the time, monetary union was deemed essential for two key purposes:

Completing the single market: Although the Single European Act had created almost completely free internal trade in goods and services, businesses still needed to exchange national currencies when trading across borders. This currency exchange increased transaction costs. A single currency was therefore seen as necessary to complete the single market by eliminating these costs.

Reducing exchange rate instability: Upward and downward movements in EU national currencies led to artificially undervalued and overvalued exchange rates within the trading bloc. These exchange rate fluctuations created an uneven playing field. Countries benefiting from falling exchange rates gained competitiveness, while countries with rising exchange rates lost competitiveness. Monetary union would establish a level playing field for all member countries by eliminating these fluctuations.

Current membership

The UK government decided to maintain the pound and not replace it with the euro. This means that alongside nine other EU member currencies, the pound was not part of the eurozone. As of February 2023, 20 EU member states participate in the eurozone. Additionally, non-member states such as Kosovo and Montenegro have pegged their currencies against the euro, and various other countries have done the same.

Currency unions and economic integration

The euro was established to facilitate greater economic integration among EU member states. Many economists view the euro as a stepping stone towards full monetary union between EU states and, potentially in the future, towards a much fuller economic and monetary union (EMU).

The impact of the euro on eurozone economies

When the eurozone first came into existence, proponents claimed that member countries would benefit in the following ways:

• Reduced transaction costs from eliminating currency exchange
• Elimination of currency risk when trading within the eurozone
• Greater transparency in pricing, making it easier to compare prices across countries
• Possibly greater competition because prices became easier to compare

According to economist Paul Krugman, the creation of the euro was intended to be another triumphant step in the European project. Economic integration had been used to foster political integration and peace, and a common currency was expected to bind the continent even more closely together.

Krugman's critique

However, Krugman then stated a very different reality:

Mobility of labour

Krugman and many other economists foresaw potential problems in eurozone countries because they recognised that the eurozone is not an optimal currency area. To understand this concept, we need to examine what makes a currency union successful.

The USA and the UK, which we mentioned earlier as currency union examples, are much closer to being optimal currency areas. Each uses a single currency, enjoys complete internal free trade, and has a fiscal policy as well as a monetary policy covering the whole of the union. Crucially, the USA also enjoys high mobility of labour, which enables workers who lose their jobs in poorer parts of the country to find jobs in richer states such as California.

Why labour mobility matters

Mobility of labour and a common fiscal policy are essential if a common currency area is to become an optimal currency area. Without the ability for workers to move from poorer parts of the union to richer parts, or perhaps to other parts of the world, the main way a country can regain jobs lost due to lack of competitiveness is through a large fall in real wages. This would make the region more competitive.

However, without a single currency, a country could restore its competitiveness by devaluing its currency. In a currency union, this option is impossible. A high degree of labour mobility is therefore needed to address unemployment problems. When workers emigrate, they shrink the size of the labour force to match the number of jobs available. However, this solution has drawbacks - it is often the young and more dynamic workers who move, which can be counterproductive for the region losing them.

Importance of a common fiscal policy

A common fiscal policy is particularly important because it allows wealth to be transferred by a centralised fiscal authority from richer to poorer parts of the union. Transfers of wealth through taxation and public spending are essential to counter the fact that poorer parts of the union cannot achieve competitive advantage by devaluing their national currencies. Fiscal transfers can help to reduce inequality but can also be used to try to improve the competitiveness of poorer regions, for example, by spending on improving infrastructure.

Lack of coordination in the eurozone

An optimal currency area requires coordination in fiscal policy as well as monetary policy. The European Central Bank (ECB) achieves monetary policy coordination, but there is no supranational authority in the eurozone similar to the ECB to coordinate fiscal policies and to facilitate significant fiscal transfers.

The lack of fiscal policy coordination has contributed to some eurozone countries developing high levels of government debt. This problem has been particularly acute in countries such as Greece and Portugal in the southern eurozone. Governments in this part of the eurozone believed they would always be helped by the richer governments of countries such as Germany and the Netherlands.

The debt crisis

Prior to the 2008-09 recession, southern eurozone countries could borrow cheaply on international capital markets. During that time, any euro-denominated debt was considered acceptable to investors, regardless of which eurozone country issued the debt. However, when the financial crisis hit, these assumptions were challenged, leading to a sovereign debt crisis in several eurozone countries.

Conclusion: an incomplete single market

The single market means that in theory there is complete mobility of both labour and capital within the EU. In practice, however, labour mobility is limited, particularly in comparison with the USA where workers move in large numbers from state to state.

Capital mobility challenges

With regard to capital, before the financial crisis in 2007, there was massive capital movement from Europe's core (mainly Germany) to its periphery. This led to an economic boom in the periphery and significantly higher inflation rates in southern eurozone countries than in Germany.

However, when private capital flows from the core to the periphery came to a sudden stop in 2008, the southern countries were left uncompetitive. Their prices and unit labour costs were well out of line with those in the core. Suddenly the eurozone faced a major adjustment problem that it has yet to deal with fully. (Austerity measures appear to have had some success in countries such as Ireland, but less so in Greece.)

Extension: Optimal currency areas

Requirements for a successful currency union

If several countries use the same currency, their inhabitants will benefit from currency gains. They no longer have to worry about possible future changes in exchange rates, and the costs involved in currency conversion disappear. These gains will be greater when:

• The countries are more economically interconnected in terms of their trading relationship
• There is freedom for labour and capital to move between countries
• There is a unified fiscal policy covering all member countries

In these circumstances, the advantages of adopting a common currency can lead to benefits for all the member states within the currency union.

Why the eurozone falls short

Although eurozone countries trade extensively with each other, capital and especially labour are not sufficiently mobile between countries, and the countries lack a unified 'government' budget. Even with freedom of movement allowed under EU law, workers are less mobile (meaning less willing to physically move for jobs) across borders in the eurozone.