Academic journal article Atlantic Economic Journal

The Euro after Three Years

Academic journal article Atlantic Economic Journal

The Euro after Three Years

Article excerpt

At the beginning of 1999, 11 countries (Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxemburg, The Netherlands, Portugal, and Spain) entered Stage Three of the European Economic and Monetary Union (EMU), thereby abandoning their national currencies for the common currency euro; 2001 Greece followed. Among the member states of the European Union (EU), only three countries which did not want to join for political reasons (Denmark, Sweden, and the United Kingdom) continue to have a currency of their own. The historical importance of this institutional change can hardly be overestimated: for the first time in history, independent states voluntarily gave up their sovereignty in monetary matters, including monetary policy. Although the euro became visible to the European public and most outside observers only with the introduction of notes and coins at the beginning of 2002, the decisive step towards monetary integration was made already three years ago.

It is therefore appropriate to take stock after these three years and to ask what has become of the project EMU and the euro so far. This should be of interest not only to the Europeans themselves but to economists of all countries, given that the euro zone is not much smaller (in terms of real GDP, population, or geographical area) than the United States and may become even bigger than the U.S. when additional countries (already in the EU or joining it in the next round of EU enlargement) adopt the euro as legal tender. Of course, any evaluation of what has and what has not been achieved with respect to the aspirations originally associated with the advent of the EMU must be very preliminary. This is particularly clear if we recall that some of the main advantages of a common currency, such as reduction of transactions cost and exchange rate uncertainty, are essentially long-run and may have visible effects only after decades instead of years. Nevertheless, even if a comprehensive analysis of the successful and less successful aspects of the creation of the euro has to be postponed, several observations as to whether this process can be regarded as a success or a failure can already be made now.

When it became clear that EMU would become reality, many observers conjectured that the euro will be a strong currency, possibly appreciating against the U.S. dollar and challenging the dollar's hegemony as an international currency [for example, Mundell, 1998; Portes and Rey, 1998]. Neither of these expectations has been fulfilled so far. In particular, the euro has strongly depreciated against the U.S. dollar over the first three years of its existence, as can be seen from Figure 1. This development of the dollar-euro exchange rate came as a big surprise to most economists, and to some extent it remains a puzzle until now.

The picture looks less dramatic if we consider a longer time period, including the depreciation of most European currencies against the dollar in the early 1980s and their subsequent appreciation until 1988. This can be seen by looking at a hypothetical dollar-euro exchange rate over the years since the beginning of the European Monetary System (EMS) in late 1979 (Figure 2). In view of the experiences of the 1980s, the depreciation of the euro by less than one third since January 1999 does not seem completely erratic. Nevertheless, and in spite of the recent reversal of this trend in the dollar-euro exchange rate, the question as to the possible causes of the external weakness of the euro remains.

From elementary economic theory we know that there is no possibility to predict the future development of an asset price (such as an exchange rate), and empirical studies have confirmed this insight by showing that random walk models of exchange rates outperform structural models in terms of forecasting accuracy [Meese and Rogoff, 1983]. However, this does not preclude attempts at explaining (at least partly) the development of the exchange rate of the euro. …

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