The Euro’s March to … Where?

Viewed in isolation, the recent decision by Swedish voters to reject adoption of the euro as their currency could be judged a small matter. It was one vote in one moment in time by one country with a relatively small economy, and its outcome was not unexpected. Still, the vote has reverberated throughout Europe because it says a lot about the ongoing tensions in the continent’s decades-long, often wrenching, march toward integration.

 

According to experts at Wharton and at universities in Europe, the vote says as much about politics as economics, perhaps more so. Some of these experts suggest that the vote underscores the wariness with which many people view the further consolidation of power within the European Union and the potential loss of a large degree of national sovereignty. Others say anti-euro forces exaggerate the threats to sovereignty and confuse the narrow issue of adopting the euro with broader, more contentious, issues related to integration. These scholars also note that the euro’s defeat in Sweden may draw attention to ways in which economic integration could be improved.

 

Some predict it is inevitable that the remaining major countries not using the euro will, in the years to come, choose to do so. For others, the future is not as clear.

 

“In the case of the euro, one can never overlook the political agenda,” says Wharton finance professor Richard J. Herring, director of the school’s Joseph H. Lauder Institute for Management and International Studies. “Behind it all is the idea that institutions can be built to tie the major European countries so tightly together that there will never be another war in Europe.”

 

Of the 15 members in the EU, only Sweden, Denmark and Britain remain outside the “eurozone,” which is comprised of the 12 EU countries that use the euro as their common currency. Plans for the euro were originally spelled out in the 1992 Maastricht Treaty. The common currency was officially introduced in 1999, and last year actual euro notes and coins were put into circulation. Citizens of Denmark voted in a referendum in 2000 to reject the euro. Britain has yet to hold a referendum, but polls there have shown a majority of citizens to be against the idea.

 

As in Britain and Denmark, the euro has become a “very political issue” in Sweden, says Antonio Fatas, professor of economics at INSEAD in France, adding that a discussion of the economic benefits and costs of adopting the euro were present in the run up to the Sept. 14 vote in Sweden, but that people did not cast ballots based purely on economic concerns. A majority of Swedes apparently saw the vote as posing a straightforward question: Do Swedes want closer ties with a bureaucratic and heavily regulated European economy? Their answer, by a margin of 56% to 42%, was: We prefer to keep our distance.

 

Wharton Finance Professor Franklin Allen, who was visiting Sweden when the vote took place, says many people were angered by the behavior of Germany and France, the two biggest economies in the eurozone. In the eyes of these voters, France and Germany seem to feel that one set of rules applies to them while another set applies to smaller nations.

 

A lot of people, says Allen, “were distressed about the way the French and Germans are trying to stimulate their economies by so cavalierly breaking the growth and stability pact,” which requires that budget deficits of eurozone countries not exceed 3% of their gross domestic product. “In a small country like Sweden, where people are extremely law abiding and conscientious, they feel that if somebody says they’re going to do something they should do it.”

 

Pros and Cons of the Euro

Proponents of the euro say a single currency offers surefire benefits. Businesses and consumers enjoy a single market for products and services in which transaction costs and the uncertainty associated with exchange-rate risk are eliminated. Proponents also say that, by using the euro, countries are likely to attract more foreign direct investment.

 

“Companies are going to be looking to export from your country to the euromarket, which rivals the U.S. in size,” Herring explains. “And you’re more likely to be comfortable doing that in a country where the exchange rate is not out of line with the euro exchange rate.”

 

Andreas Busch, university lecturer in comparative European politics at Oxford University, says that since all European countries, but particularly those in the EU, have close trading links, many of their exports were once threatened by exchange-rate volatility. “Europeans have always attached a very high priority to the elimination of exchange-rate risk,” Busch notes. “If we look back to the years after the Second World War, we had the Bretton Woods system of fixed exchange rates. That worked until the ‘70s. Then it broke down. The Europeans have always tried to get back to the exchange-rate stability that most countries enjoyed.”

 

Busch says he cannot understand why many people in Sweden, Denmark and Britain are reluctant to support the euro. “It’s puzzling. Why would a country like Denmark not want to do it when a country like Belgium wants to do it? Why would a country like Britain not want to do it while France does it? It never was a very contentious issue for the countries that are in the euro area. The euro is not at all a contested issue in Germany, France or Spain.”

 

Opponents of the euro worry that by relinquishing monetary policy to the European Central Bank (ECB), individual nations give up their ability to set appropriate interest-rate levels to deal with inflation, recession and shocks to the economy. A single, centralized monetary policy, according to anti-euro forces, cannot work effectively for each and every country in the eurozone – despite assertions made by euro proponents that, over time, the ECB will develop the experience and credibility to keep inflation low for all nations that use the euro.

 

Such worries played a role in the euro’s defeat in Sweden, according to Michael Kitson, university lecturer in economics at Cambridge University’s Judge Institute of Management. There was concern that Sweden would lose control of its economic policy by embracing the euro and be compelled to accept a “crude, one-interest-rate-fits-all-of-Europe” monetary approach. Since eurozone countries are required to abide by stringent budget controls, many Swedes feared their extensive welfare system could be placed in jeopardy.

 

Sweden historically has been a country happy to have relatively high levels of taxation to fund a strong and efficient welfare state,” says Kitson.

 

INSEAD’s Fatas suggests that people frequently make the mistake of confusing the narrow issues surrounding the euro with broader issues related to overall European integration. Sweden, Britain and Denmark are already full members of the EU, he argues, so it is difficult to understand why adopting the euro is such a major political issue. “There is some confusion over what the euro project means. The euro [simply] means having a single market and some legislation that is the same in all countries … [The euro] means you share the same currency. It’s very clear. No one disagrees. If you ask companies, they say, ‘We want one currency.’ If you ask citizens, they say the same thing.”

 

Fatas believes the benefits of the euro outweigh the negatives. “Once you give up your currency, you give up your central bank. If you give up your central bank, it means you can’t control your interest rates. How large is that cost? That’s the argument among economists: Not having your own central bank means to some that you cannot control your own economy. You can’t get your economy out of recession. I see that as a minimal cost.”

 

Herring, however, says concern about the negative effects of giving up national control of monetary policy is far from misplaced. Relying on the ECB “is fine if you think the shocks to your economy will be like the European average. But if you think you’re not a typical European country, and you experience a whole variety of shocks from oil or commodity prices, then the eurozone monetary system may not be right for you. It may even be perverse for you. So how do you adjust if you don’t have your own national monetary policy to help? It will put a lot more pressure on fiscal policy and on domestic price flexibility, neither of which is notably flexible in most European countries.”

 

A Lack of Data

The argument over the costs and benefits of a single currency would seem easy to resolve: The euro has been around for four years now, so how well has it worked? The problem is that not enough time has passed and there has not been sufficient research to answer that question with any degree of certainty, according to Wharton’s Allen. Moreover, it is difficult, if not impossible, to figure out what would have happened to eurozone economies had they not adopted a common currency.

 

“Does the advantage that you have from a stable currency, so you can make better investment decisions, outweigh giving up monetary policy? I’m not sure where that trade-off comes out,” Allen notes. “One argument is that the economies of Sweden, Denmark and Britain are doing so well that maybe they should have separate monetary policies. The franc and the deutsche mark used to move fairly closely together, so it may make sense for them to have a joint currency. It’s a mix of politics and economics and the answers are not clear. Some people once thought that once we get the euro, we will have much more efficient capital markets in Europe. But it’s not clear that has happened.”

 

“There has been a number of great advantages [from the euro] but it depends on the country,” adds Busch. “Some countries have profited more than others.” Spain and Italy, for example, have seen interest rates decline by several percentage points in recent years, which has given a big boost to their economies.

 

It is true, for example, that Germany’s economy is struggling – with low growth, high unemployment and high real interest rates – while Denmark, Britain and Sweden have enjoyed better economic performance. But it is impossible to blame the euro for Germany’s woes, which stem at least in part from the huge costs the government has incurred to achieve the reunification of the former West Germany and East Germany.

 

Germany is often now considered the ‘sick man’ of Europe, having taken that role over from Britain,” Busch says. “But I want to emphasize that reunification has been dramatically expensive for the Germans. One must be aware that [the government] transfers 3% of GDP each year to eastern Germany.”

 

Busch believes that the euro will benefit Germany in the long term. “You could argue that Germany has lost the particular advantages it had enjoyed [before the euro], since it always had low inflation rates. But, in other respects, Germany, being Europe’s biggest economy – very strong and export oriented – has gained by having exchange-rate volatility eliminated. Germany now can make contracts with French customers and know what the prices will be. They have absolute certainty about this. They couldn’t do this before.”

 

Fatas makes a similar argument that the euro cannot be blamed for the sluggish eurozone economy, which is expected to grow by a mere 0.5% in 2003, according to forecasts by the European Commission, the EU’s administrative arm, and the International Monetary Fund. He says “2002 and 2003 has been a period of low growth. But of course that applies to any country, like the U.S., which is not part of the European Union. If you ask economists, ‘How much does a single currency improve economic performance?’ they would say, ‘Very little.’ Japan has its own currency and that economy has been a disaster for 10 years. Having your own currency doesn’t destroy structural problems.”

 

An Evolving View

Kitson, of Cambridge’s Judge Institute, says he used to be strongly opposed to Britain’s joining the eurozone, primarily because of the dangers inherent in giving up national monetary policy. But his views have changed. Today, he favors a single currency, as long as changes are also made in the EU’s fiscal policy and that mechanisms are put in place to help spur economic growth in those countries whose economies are not doing as well as the rest of Europe. Tax revenue collected by the EU, he says, should be distributed to nations that need help.

 

“I’ve increasingly come to think there will be some benefits to the single market if we have some additional requirements for an integrated Europe,” Kitson says. “At the moment, it’s a half-baked policy. If we were to develop a more efficient fiscal policy and an industrial regional policy in Europe, the potential pitfalls of a single currency could perhaps be reduced or eradicated. A coordinated fiscal policy would have a centralized taxation framework.”

 

But Kitson recognizes that “the problem with my system is it gives up even more power to Europe. Tax and spending has to be coordinated. But you have to make that accountable at the local level. I still have major concerns, but I think my reservations are evolving.”

 

Looking Ahead

It may be years before Sweden holds another referendum on the euro. Denmark may vote again next year. As for Britain, the timing of a first-ever referendum will hinge to a large extent on the political fortunes of Prime Minister Tony Blair. Blair has been criticized for supporting U.S. policy in Iraq and remains embroiled in a controversy over the apparent suicide of a government weapons inspector who was the source of a BBC report on allegations the government exaggerated the threat posed by weapons in Iraq. Blair supports Britain’s entrance into the eurozone, but Gordon Brown, Britain’s chancellor of the exchequer, is not as keen on the idea.

 

“If Tony Blair is still in power, he’d like to lead Britain into the euro,” Kitson says. “He sees that as an important part of his political project. If the Conservatives win the next election, we won’t go into the euro, but a win by the Conservatives is unlikely. If Tony Blair stays, we will go into the euro in the next five years. If Blair leaves and Brown becomes prime minister, joining the euro will be delayed.”

 

Fatas and Busch believe it is just a matter of time before Denmark, Britain and Sweden adopt the euro. “My prediction is these three countries will one day join the euro,” Fatas says. “The only question is when.”

 

Allen is not as sanguine. He says many Britons, Danes and Swedes are reluctant to join the eurozone because of deep cultural and political differences with other Europeans. Many, for example, have been left wary by corruption cases involving EU officials over the years and controversial statements from Italian Prime Minister Silvio Berlusconi. Berlusconi recently made headlines by saying that Benito Mussolini, the Italian dictator during World War II, never killed anyone.

 

“People in Britain don’t see the European experiment as something they want to be a part of,” according to Allen. “There are lots of differences and they are playing out in a big way. Berlusconi is a big illustration of it. Northern and Southern European societies are very different.”

 

Allen did not predict what Sweden or Denmark might do, but he believes it will be a long time before Britons even hold a vote. “I wouldn’t be surprised if Britain didn’t do it for five to 10 years. As long as Britain’s economy is doing better than the eurozone economy, my bet is I don’t think [pro-euro forces] will win a referendum.”

 

Herring is uncertain what Britain should do. “I vacillate,” he says, but adds that he understands why many Britons feel the way they do. “Once you’ve given up your currency, people see a slippery slope toward Britain becoming part of a European government.”

 

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