0115 966 7955 Today's Opening Times 10:00 - 20:00 (BST)

Weaknesses Of The Eurozone Economics Essay


Disclaimer: This essay has been submitted by a student. This is not an example of the work written by our professional essay writers. You can view samples of our professional work here.

Any opinions, findings, conclusions or recommendations expressed in this material are those of the authors and do not necessarily reflect the views of UK Essays.

Robert Mundell described the Bretton Woods System as Hamlet without the Prince due to the lack of a unified currency in the form of a monetary union expressed as Bancor or Unitas. Given the experience of EMU, does this analysis still hold theoretically and/or empirically? Discuss.

Introduction of EMU

In 1999, the European Central Bank (ECB) launched the single currency (euro) together with the foundation of the Economic and Monetary Union (EMU). The EMU is based on the existence of the euro as a common currency. The ECB supervises the implementation of a common monetary policy. At the beginning of 2002, euro replaced the national currencies of 12 member countries for all transactions. Sweden, Denmark, and the United Kingdom joined European Union (EU) but did not join the euro. In 2004, there were ten new member countries joined the EU, five of them joined the euro.

The prior monetary unions are unsuccessful as they rested on the value of metals (i.e. gold or silver). The money printed should be determined by the silver of gold stored, therefore the Metallism monetary system is a stable system since silver and gold are scarce resources.

The EMU rests on the euro or chartalism, as fiat money which is issued by a central national bank. The credit level of the issuing body is important to determine the value and stability of the fiat money. The stability of the country in terms of economic and political will in turn determine the credit level. However, when the treasury is unable to finance the deficit, fiat monies can become unstable due to the temptation of the inflationary tax or seigniorage. In order to achieve and sustain the stability, the EMU needs an economic union and a monetary union. Economic union is achieved by complying with the Stability and Growth Pact (SGP). The goal of SGP is to maintain fiscal stability through implementation of specific fiscal requirements among member states of EMU.

The strength of the Eurozone rests completely on the credibility of the requirements set when the EMU was being implemented and the ECB was established. However, if member states are not respect or follow the set requirements, the credibility level of Eurozone will be affected and as a result negatively affect the euro.

Mundell's Theories

The original idea of a common currency in Europe was derived from the theory of Robert Mundell on the areas of optimal currency. In his paper "A plan for a European Currency" in 1973, Mundell clarified the gains of European countries if they adopt a common currency. The works of Mundell have been classified into two categories by Ronald McKinnon (2004).

Mundell I

In 1961, Mundell published his paper entitled "A Theory of Optimal Currency Areas" which is rooted in Keynesian ideas. The theory of Optimum Currency Areas (OCAs) studies how countries with a monetary union and common currency adjust, if these countries are affected by asymmetric economic shocks. Mundell point out that adjustments are based on whether wages are rigid, labour mobility is limited, income transfers are difficult, and differences exist in the labour market and growth rates. Mundell claimed that when countries are in a monetary union and use a common currency, they cannot absorb asymmetric shocks properly unless, among other circumstances, labour mobility is unlimited.

Mundell II

In Mundell's article "Uncommon arguments for common currencies" which published in 1973, an alternative theory is illustrated. Mundell emphasised "the common currency assures an automatic and equal sharing of the risk of the fluctuation", a common currency has advantages in overcoming economic shocks. Mundell II argues that it is easier for member countries to stay inside a monetary union than outside it since the private insurance would assist against asymmetric shocks. More specifically, it will be easier for member countries to borrow in the capital markets of the monetary union when hitting by a negative shock, as a result it will be easier for member countries to smooth consumption. In addition, the exchange rate would be a source in arising asymmetric disturbances; especially capital mobility of financial market is very high.

The criticism of Mundell II becomes more obvious in terms of political context. If financial markets in a monetary union provide insurance to reduce asymmetric shocks, the need to integrate national budgets for political means becomes weaker. Hence the motive to form a political union is even weaker. However, the Mundell II point out that if there is no budgetary union, it would be optimistic to say that private financial markets would provide insurance against asymmetric shocks. The financial markets will only provide insurance to those who possess high assets stock in the financial markets. Since wealth is not equally distributed, the private provision of insurance will overwhelmingly support the wealthy and keep the poor relatively uninsured. In addition, the Mundell II theory ignored the possibility that countries may involve in a position of a 'bad equilibrium'. If there are not adequate instruments to lead the economy out of the bad equilibrium, countries would get caught in the bad equilibrium after a negative shock. It is a major problem for the future of EMU if there is no adequate instrument in a monetary union. This is reinforced by the fact that different member countries of EMU continue to work in different directions due to the absence of a political union.

Weaknesses of the Eurozone

In the last ten years, the euro has demonstrated that there are many efficiency gains by adopting a common currency (i.e. reduced transaction costs of exchanging currencies, eliminated exchange rate uncertainty, and increased transparency in prices), particularly if the currency becomes not only an international currency but also a global currency. However, maintaining various standards requires difficult adjustments and constant surveillance of every single member state in Eurozone.

As the economic crisis has hit the world, certain Eurozone Member States - Greece, Portugal and Spain are being seriously affected. The Greek tragedy is making the EU realize that highly indebted countries can put the EMU at risk and that measures must be taken without delay.

Institutional Weakness

Article 102.a of the Maastricht Treaty establishes that member states and the community should "conduct their economic policies with a view to contributing to the achievement of the objectives of the Community". In order to guide Article 102.a, Article 103 highlights that the correct implementation of economic policies is a matter of common, stating that "Member States [are to] coordinate them within the Council, in accordance with the provisions of Article 102a". Article 103 also highlights that it is important to avoid excessive deficits of each government. There is an obvious institutional weakness in terms of monetary policies. The Maastricht Treaty had defined the objectives of the ECB which is price stability. ECB has defined an inflation rate below 2% as the objective of price stability. In addition, in terms of unemployment, the rest of society is not convinced and will not easily accept the attempt of the ECB to release itself from any responsibility for unemployment. However, the delegation of the responsibility of unemployment to the governments of each member country creates a political problem.

The purposes of SGP contain that member countries should avoid excessive debt and deficits and each member country should maintain fiscal stability. There are two important two Council Regulations in SGP (i.e. Regulations 1466/97 and 1467/97). These two regulations require member countries of the EU must comply with to help "contribute to the overall climate of stability and financial prudence underpinning the success of the EMU". The Council Regulation 1466/97 set out the details of stability programs (i.e. submission and monitoring regulations) and convergence programs. The ultimate purpose of the multilateral surveillance by the Council is to prevent, at an early stage, the occurrence of excessive general government deficits and to promote the surveillance and coordination of economic policies. The purpose of regulation 1467/97 is to clarify the excessive deficit procedure to deter excessive government deficits (European Navigator 1997, 2). However, the SGP is not sustainable due to the lack of accountability of the EU commission. Hence, the national governments are bound to win when conflict arises. The problem will exist as long as national governments continue to possess the sovereignty over spending and taxation.

Political integration

De Grauwe (2006) acknowledged that the EMU is a remarkable accomplishment, but the absence of a political union is a major weakness in the Eurozone governance. Grauwe's view is consistent with the findings of Nitsch on the political integration. He conclude that "political integration is not rapidly followed by economic integration" (Nitsch and Wolf 1). Grauwe point out in his article that national governments holding most economic policies decision creates asymmetric shocks. The asymmetric shocks truly affect the sustainability of the monetary union. For example, member countries of the Eurozone have different competitive positions due to the uncoordinated policies of each member country in relation to national wage.

Italy, Ireland, Portugal, Greece and Spain were in constant financial and economic turmoil before the adoption of the euro. The turmoil situation disappeared due to the economic booming of the past years. These five countries have barely met the requirements of monetary and economic stability and are becoming increasingly difficult to maintain the stability. For the past years, these countries are not only suffering from excessive deficits and debts, but also economic unbalances (i.e. excessive current account deficits). The current account positions are becoming worse 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 originates from the fact that monetary union amplifies fiscal imbalances. Opting for devaluation of a competitive currency is not an option and the only other alternative stems from forcing differentials of bond yield reduced. 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 has increased government default risks measured by a sudden increase in the demand for credit default swaps. Hence, the current economic crisis has demonstrated that currency risk is replaced by default risk in a monetary union. There are two reasons for this situation: 1) the sovereign debt of each member country is issued under the control of each Ministry of Finance, 2) there is no European Ministry of Finance.

The Germans has proposed the creation of a European Monetary Fund, the French league has proposed the creation of a European Debt Agency which required that the Lisbon Treaty were amended or that a new treaty were negotiated. Many people blamed this situation due to the lack of a common bond market which would help to put all members together. Some people reject the suggestion based on the fact that a common bond market would lower borrowing costs for weaker countries and increase costs for stronger countries such as Germany. In addition, the common bond market would obtain the budget rights from each governments which would not be able to make national budgets by themselves.

Exit clause

For years some countries have not respect or followed the requirements listed in the Maastricht Treaty and are now facing extremely difficult economic situations. It is obvious in the current crisis that there is no political homogeneity among member countries from a political point of view. As a result, each member country has implemented its own particular economic model and how to conduct its own economic model. In addition, Greece, Spain, and Portugal do not truly realise that their economic models are embedded in a globalised economy and these countries need to implement a set of painful structural reforms to keep them competitive. From the economic point of view, the countries in trouble have two major common reasons. The reasons are the lack of respect for the requirements and the lack of appropriate implementation of the structural reforms required under an economic recession.

Currently there are debates on what should or should not be done with these countries. However, there are not room to manoeuvre this situation under the current legal framework.

Expulsion of these countries from the Eurozone is not a good choice as it would definitely hurt the image of the EU and its member countries. Many scholars, economists propose that voluntary withdrawal from only the Eurozone while staying in the EU to would be the most beneficial option.

The legal framework - the Treaty of Lisbon, does not provide the necessary methods to deal with problems of withdrawal, expulsion from Eurozone nor any other similar problem that might arrive soon. First, the Treaty of Lisbon has the "no-bailout" clause to prevent a budgetary problem in one country spilling over the EU as a whole. The no-bailout clause prohibits member countries from rescuing other countries or from accepting the debts of other countries. However, the Article 122 of Lisbon Treaty states that any member country "seriously threatened with severe difficulties caused by natural disasters or exceptional occurrences beyond its control" can receive financial assistance from other members. The question is whether a member country's current debt crisis could qualify as an "exceptional occurrence" and not a "man-made" issue. This clause was inserted to strengthen unity and commitment of Eurozone. But the reality is that some countries are possessing extremely high level debts and deficits far exceeding the requirements. Therefore, there are not many methods for to assist these financial troubled countries under the current circumstances. The Articles 4(2), 118, and 123(4) explicitly indicates that the process for adoption of the Euro is irreversible. Participation of the EMU becomes a legal obligation due to the irrevocability of the agreement and the monetary union process. Thus, the exit option of leaving EMU while staying in the EU is impossible. The exit option is only allowed to exit the EU and EMU altogether.

In addition, there is no clear mechanism by which members could expel a fellow country. The expulsion could only be possible if the treaty were amended and provided that all member countries respond favourably to this amendment.


The EU and the Eurozone are suffering not only a financial crisis, but also a totally lack of appropriate structural reforms. The proper functioning of the EMU depends on the compliance with requirement provided in monetary and fiscal policies. Some member countries need to adopt urgently a number of structural reforms to promote economic growth of its own country and to stable euro as part of the EMU. Most importantly, the EMU should take this crisis as an opportunity to create a restructuring mechanism to strengthen and reform the economic, political foundations of the euro project.

To export a reference to this article please select a referencing stye below:

Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.

Request Removal

If you are the original writer of this essay and no longer wish to have the essay published on the UK Essays website then please click on the link below to request removal:

More from UK Essays

We can help with your essay
Find out more