The Effect of the European Debt Crisis on the Euro Iris Zhang Ryan Scheb Ben Crayton Will Hadley Intro The debt crisis that swept across Europe, for better or worse, changed the economic and financial world as we know it. While the European debt crisis affected the markets in many ways, we focus on the effect it had on currency: specifically the Euro, non-Euro European currencies, and the US Dollar. While the Euro initially plummeted while analysts initially speculated about the end of the European monetary union, the merging of fiscal and monetary policy soon allayed most, but not all fears. However, non-Euro countries in Europe did not fare better. The British Pound Sterling plummeted in value while the Swiss Franc strengthened dramatically. Overall the effect has been negative and has only led to the further contraction of European economies. While the Euro was fluctuating drastically, the United States dollar continued to be seen as a safe haven for worried investors; during times of instability, the dollar would appreciate against the Euro as investors scrambled to move towards a safer investment. However, the Euro as a currency seems to have emerged from this debt crisis strengthened rather than weakened. The Effect of the European Debt Crisis on the Euro The Euro was implemented to help stabilize the economy in Europe, and also to strengthen Europe‟s presence in the global economy. Up until most recently the Euro has had positive effects throughout Europe. However, the current Debt Crisis has lead to a tremendous amount of uncertainty across all of Europe, and even globally, as the strength and stability of the Euro is put to question. Ultimately, the euro held together countries, for better or for worse, as they went through the European financial crisis. While countries like Germany were reluctant at first to aid fellow member states, having a common currency pushed Eurozone countries to agree to an aid mechanism that prevented the financial crisis from spreading. In the end, while nationalistic feelings across Europe threatened to break the monetary union, the benefits to sticking to the Euro outweighed the costs. Examining the history of the Euro gives an idea of the changing views people have had about the currency over the past decade. Up until most recently the Euro has been associated with stability, and has been an achievement for new nations to changeover from their domestic currencies. Traditionally the benefits of adopting the Euro have outweighed the costs, but many countries doubt the Euro in light of the recent debt crisis. The potential fall of the Euro and the Eurozone has sent a scare throughout all of Europe. However, the EU and the IMF have set forth reforming policies in an effort to keep the Euro afloat. The doubt in the Euro is not without cause, but a total examination of the crisis concludes that the Euro, and the single currency system, was beneficial to recovery efforts. The origin of the Euro is directly tied to the origin of the European Union. The idea of a united Europe came about after the Second World War, as people realized Europe could not survive another similar war. Initially European countries came together for economic purposes and created the European Economic Community in 1957. The founding nations consisted of Germany, France, Italy, Belgium, the Netherlands, and Luxembourg. The stated purpose of the community was to allow “people, goods, and services to move freely across borders” (European Union History). The community experienced growth in many areas, and began adopting new laws, as well as its own governing body. EEC members proposed plans to stabilize the whole European economy, and protect currencies from large fluctuations. In 1972, the EEC created an exchange rate mechanism, which only allowed for a narrow range of fluctuations amongst the European currencies. This mechanism was the initial step towards the creation of the Euro. In 1993 members of the European Economic Community met and signed the Maastricht Treaty which created the European Union, and expressed the intent to create a single European currency. It was not until January 1st, 1999 that the Euro became an accounting currency. Initially the Euro acted in much the same way as the exchange rate mechanism. Participating countries fixed their domestic currencies to the Euro, which prevented the currencies from fluctuating against the Euro, and also against other neighboring currencies. This non-paper currency was only used in commercial and financial transactions, and was adopted by 12 countries, with notable hold-outs including the United Kingdom and Denmark. On January 1st, 2002 the Euro became a legal cash currency. The changeover from domestic currencies to the Euro brought about unity, but it also brought about costs which were seen in all aspects of Europe‟s economy. The Euro is now the unit of currency amongst 17 members of the European Union (History of the Euro). The adoption of the Euro required the exchange of approximately 15 billion notes, as well as 50 billion coins. Throughout the Eurozone the changeover created costs of all kinds for governments and businesses. Retail businesses required two cash registers in order to begin cycling out the domestic currencies. This process raised transaction times, which led to a turnover decrease of around 10%. There was also wide-spread fear of rip-off pricing as the Euro exchange rates were fixed at a very precise rate. Consumers feared retailers would “round-up” the exchange rates in order to cash in on the opportunity presented by the Euro changeover. Consumer spending fell as a result of this fear, which led to a temporary weakening of the Eurozone markets. There were also extraordinary costs associated with the actual changeover such as public awareness campaigns, changing payment systems, and the production of the new notes and coins. These changeover costs were estimated to be 160 to 180 billion Euros. The costs associated with the implementation were large, but they were also onetime expenses, which led to many benefits throughout the European Economy (The Costs and Benefits of the Euro). Examining the history of European economies leads to the conclusion that there is a reasonable correlation between the adoption of the Euro and the improved economic growth in Europe after the Euro changeover (History of the Euro). The Euro has brought about an increase in macroeconomic stability, and a more efficient European market. The adoption of the Euro has also led to decreased transaction costs associated with tourism and trade amongst the Eurozone countries. Another large benefit of the common currency is the drastic increase in price transparency. Easy price comparisons across Europe allow firms to purchase cheaper raw materials, and consumers to purchase cheaper goods. Monetary policy for the Eurozone is managed by the European Central Bank, an entity of the European Union. The ECB sets interest rates throughout the Eurozone with the primary objectives being stability, and low inflation. Although the ECB is tasked with helping the economies of the Eurozone, it does limit the governments‟ fiscal policies, as interest rates are no longer in their control. The benefits of the single European currency do not seem to outweigh the negative effects, as many countries have adopted the Euro since its introduction a decade ago (Benefits of Joining the Euro). Transitioning to the Euro is not an easy process for an EU member state. The EU has determined a set of standards, known as convergence criteria, which member states must meet in order to join the Eurozone. These criteria are put in place to ensure the economy of the country is stable and strong enough to adopt the Euro without bringing negative consequences to other Eurozone countries. Before a country can transition to the Euro, its domestic currency must spend two years attached to the European Exchange Rate Mechanism, which is previously defined. While participating in the exchange rate mechanism, the currency must not devalue in comparison to a currency of another member state. Additionally, the price stability, or inflation, of a state must be within 1.5% of the three top-performing member states in the Eurozone. Another criterion to be met is the stability and sustainability of the government‟s financial position. The ratio of the government‟s annual deficit to GDP must not exceed 3%, or must be declining and approaching that 3%. Also, the ratio of the government‟s debt to GDP must not exceed 60%, or must be sufficiently decreasing towards 60% at an acceptable rate. The final criterion that must be met addresses the “durability of convergence” based off of the country‟s long-term interest rates. The nominal long-term interest rates of the country must be within 2 % of the three top-performing member states (Introducing the Euro: Convergence Criteria). These top three states will be the same states used in the price stability analysis. The values used in these convergence criteria are not a long historical analysis. The timeframe taken into consideration is the one year period prior to examination, except in the case of the exchange rate mechanism, which requires two years of participation. Since the initial changeover of the Euro in 2002, five additional countries have undergone the examination, fulfilled the criteria, and become part of the Eurozone. The following table shows the countries that are in the Eurozone, as well as the year in which they adopted the Euro. Country Date of Euro Adoption Belgium 2002 Germany 2002 Greece 2002 Spain 2002 France 2002 Ireland 2002 Italy 2002 Luxembourg 2002 Netherlands 2002 Austria 2002 Portugal 2002 Finland 2002 Slovenia 2007 Cyprus 2008 Malta 2008 Slovakia 2009 Estonia 2011 The purpose of the EU, as well as the Euro, is to bring about a more unified Europe.