Evaluating the expansion of the eurozone

Introduction

At the start of the year, Croatia adopted the euro and became the 20th country to join the eurozone. In addition, Croatia is now part of the Schengen area, allowing for the abolition of border checks for people travelling from Croatia moving between other countries that are part of the agreement (Williams, 2023). The responses to the replacement of the kuna with the euro have been mixed, warranting a broader examination of the advantages and disadvantages of joining the eurozone (Gauret, 2023). 

Joining the eurozone

To make convergence possible, countries have to meet a series of criteria that bring their national currencies closer to the value of the euro. Firstly, countries should have relative price stability, including stable inflation rates, meaning the inflation rate should not be more than one and a half per cent above the inflation rates of the top three performing eurozone members. Secondly, the government budget deficits should not be excessive and debt levels should be sustainable. Thirdly, the present currency should not be subject to extreme fluctuations; countries are required to participate in the European Exchange Rate Mechanism to ensure this. Lastly, long-term interest rates should not be more than two per cent above the interest rates of the top three performing eurozone members (European Commission, n.d.). 

Once countries have met such criteria, there are a variety of scenarios that they can choose from with regard to how the currency transition actually occurs. One such scenario is the ‘big bang scenario’, where the new currency is implemented on the same day that it is recognised – this option removes transitional periods (European Commission, n.d.). The second scenario is called the Madric scenario, which involves a more gradual transition of three years. There is also an intermediate scenario which involves a phasing-out period of one year (European Commission, n.d.). 

Advantages of eurozone membership  

A major advantage of having a shared currency is that it can lower transaction costs, attracting more foreign direct investment (Beattie, 2021), which may in turn generate deeper economic relations with other countries. Typically, investors who use foreign currencies face foreign exchange risk (Beattie, 2021). If an actor were to borrow money in a foreign currency and the value of the currency they borrowed were to rise, then the value of their debt would increase in terms of their domestic currency. Thus, the inherent risk of borrowing in another currency is that its value might suddenly rise. This was observed in the taper tantrum of 2013. After the United States Federal Reserve announced that it would start to constrain its quantitative easing program, the act of purchasing bonds to stimulate economic activity, this negatively impacted the expectation of investors (Avdjiev, 2019). The future prospect of increased interest rates led to inflows into the United States, causing the value of the dollar to rise. This harmed many holders of American currency in other countries and those engaged in cross-border bank lending, who experienced a rise in the value of their dollar-denominated debts relative to their local currency (Avdjiev, 2019). By joining the eurozone, such foreign exchange risks are removed when dealing with other eurozone members, allowing for more stability in the costs of production, borrowing from other countries, and attracting increased investment. 

Similarly, currency risks for trade are also eliminated among countries within the eurozone. This allows for increased transfer of goods and services among eurozone countries, another crucial benefit. For instance, in 2021, it was estimated that most EU member states had a share of intra-EU exports between 50% and 75% (Eurostat, 2021). Furthermore, countries within the eurozone should benefit from more efficient resource allocation, at least in theory. By sharing a currency, the removal of barriers to trade allows for freer movement of labour and capital and thus should promote greater specialisation (Mursa, 2014). This, combined with higher levels of predictability, makes resource allocation increasingly efficient. 

Another benefit of adopting the euro is the attraction of more tourists. The usual travel duties incurred when exchanging currencies are no longer necessary, making it even more convenient for tourists from the eurozone (European Central Bank, 2007). For example, in the case of Croatia, already around 70% of the tourists that visit the country come from eurozone countries (Gauret, 2023). Tourism plays a significant role in the Croatian economy, accounting for around 20% of its gross domestic product, and this is only likely to increase with the introduction of the euro (Williams, 2023).

Lastly, an important outcome of the adoption of the euro is the prevention of currency manipulation. In the past, governments have been accused of intentionally devaluing the national currency to artificially lower the price of their exports, stimulating trade and increasing export revenue (Staiger, 2010). For example, China has been accused by the United States of engaging in currency manipulation, specifically, of keeping the Chinese Yuan artificially low to promote Chinese exports (Weber, 2021). This also creates a disadvantage for importers, as they struggle to compete with domestically produced products given that the relative value of their currency has increased. Once they have joined the eurozone, individual governments can no longer manipulate their currency as such decisions are centralised within the ECB (Mursa, 2014). This removes any incentive for currency manipulation that would otherwise occur for countries with a currency of their own. 

Criticism and limitations 

The most obvious drawback to joining the eurozone that should be considered is the blanket monetary policy placed upon its members who face varying economic problems. Given the number and variety of countries, discrepancies among unemployment rates, inflation rates, and growth rates are natural (Beattie, 2021). Therefore, it is difficult to develop adjustment mechanisms that can function effectively across different countries that may be at different stages in the business cycle. During economic recessions, monetary policy can be a crucial tool. Monetary policy adjusts the supply of money in the economy in order to maintain low inflation and pursue full employment (although the latter is not within the ECB’s mandate) (Mathai, 2021). Expansionary monetary policy, often used during a recession, involves lowering interest rates to incentivise consumption and investment. At times, there has been criticism of the ECB’s response to recessions, specifically that it has been too slow (European Central Bank, 2007). Member states frequently disagree on the activities of the European Central Bank. For instance, during the global financial crisis of 2008, there were divisions between France, which held a centre-left position, and Germany, which held a more conservative position when it came to financing the debt of fellow member states’ ailing economies (McBride, 2019). 

In addition, at times, countries have been estimated to have met the convergence requirements despite not actually meeting them. After adopting the euro, Greece’s borrowing costs fell drastically from 20 per cent to just four per cent on a ten-year bond (Blyth, 2013). As borrowing became easier, Greece’s fiscal deficit worsened. In late 2009, Greece disclosed that the country’s budget deficit was actually significantly higher than the eurozone convergence criteria had established (Copelovitch, 2016). This harmed the credit rating of Greece and led to a rise in borrowing costs for Greece as well as other eurozone countries such as Italy, precipitating the sovereign debt crisis. In response to the government debt crisis, the “Troika”, made up of the European Commission, European Central Bank, and the International Monetary Fund, provided Greece with 110 billion euros in loans in exchange for Greece implementing austerity measures (International Monetary Fund, 2010). However, such measures were insufficient and Greece asked for help from the European Central Bank. Unlike national central banks, such as the US Federal Reserve, the European Central Bank did not engage in bond purchasing (Copelovitch, 2016). In 2012, the European Central Bank finally initiated a new programme in the form of outright monetary transactions (OMT). The OMT programme allowed the European Central Bank to purchase bonds from struggling eurozone countries in return for such countries implementing mandated economic reforms (McBride, 2019). 

Due to the various countries, and conflicting interests, involved, there was constant debate about how to support Greece. Many northern member states, and Germany, set clear limits on the amount of support the European Central Bank would provide for Greece (Collignon, 2012). The concept of using domestic taxpayers’ money to bail out other states’ debt was politically controversial and leaders were eager to demonstrate their opposition to it (Collignon, 2012). For instance, in 2013, the rise of the right-wing populist political party, AfD, in Germany was largely attributed to a campaign of euroscepticism, particularly regarding the support for Greece during the sovereign debt crisis (Arzheimer, 2015). Thus, the reaction of the European Central Bank did not materialise quickly. In this case, Greece was unable to pursue a monetary policy that catered to its needs as other eurozone members had to be considered as well. The European sovereign debt crisis reflected a deeper issue: if one country within the eurozone experiences an acute crisis, then it lacks the force necessary to deal with it quickly. 

Another critique of countries adopting the euro is that larger, more economically developed countries benefit disproportionately, as their interests are prioritised (Wesel, 2023). For instance, it has been argued that countries such as Germany have gained more from adopting the euro compared to Greece, Spain, and Italy (Ezrati, 2018). Especially in the context of the European sovereign debt crisis, the unwillingness of certain members to provide support to more vulnerable countries such as Greece was displayed. This highlights the inability at times to cater to the needs of relatively less economically developed countries, thus hindering their economies. Another possible reason is that, for weaker economies, adopting the euro provides an inflated currency value that places their producers at a competitive disadvantage.

Concluding thoughts  

To conclude, the process of joining the eurozone is complex and lengthy. Countries have to meet a variety of conditions regarding inflation rates, government budgets, exchange rates, and interest rates. Even after meeting the requirements, the procedure of introducing a new currency provides governments with various choices on the use of transitional periods. It is crucial to note that the implications of a shared currency are highly contested.

All in all, the discourse around the euro is incredibly nuanced, filled with both advantages and disadvantages. Despite such limitations, the advantages of currency convergence are arguably greater. Acknowledging past mistakes, such as the eurozone crisis, will hopefully serve as lessons for the European Central Bank and thus improve the currency union in the future.

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