On January 1, 1999, the European Union introduced its new currency, the euro. The euro was created to promote growth, stability, and economic integration in Europe. Originally, the euro was an overarching currency used for exchange between countries within the union. People within each nation continued to use their own currencies. Within three years, however, the euro was established as an everyday currency and replaced the domestic currencies of many member states. The euro is still not universally adopted by all the EU members as the main currency. However, many of the holdouts peg their currencies to it in some way.

Given the enormous influence of the euro currency on the global economy, it is useful to look closely at its advantages and disadvantages. The euro, which is controlled by the European Central Bank (ECB), was launched with great fanfare and anticipation. However, the euro's considerable flaws became more apparent when it was tested by a series of challenges early in the 21st century.

Key Takeaways

  • The euro was created on January 1, 1999, and it was designed to support economic integration in Europe.
  • The advantages of the euro include promoting trade, encouraging investment, and mutual support.
  • On the downside, the euro was blamed for overly rigid monetary policy and accused of a possible bias in favor of Germany.

Pros

Promoting Trade

The main benefits of the euro are related to increased trade. Travel was made easier by removing the need for exchanging money. More importantly, the currency risks were eliminated from European trade. With the euro, European businesses can easily lock in the best prices from suppliers in other eurozone countries. That makes prices transparent and increases the competition between firms in countries using the euro. Labor and goods can flow more easily across borders to where they are needed, making the whole union work more efficiently.

Encouraging Investment

The euro also supports cross-border investments within the eurozone. Investors in countries using foreign currencies face significant foreign exchange risk, which can lead to an inefficient allocation of capital. Although stocks also have exchange rate risks, the impact on bonds is far greater because of their lower volatility. The prices of most debt instruments are so stable that exchange rates influence returns far more than interest rates or credit quality. As a result, foreign currency bonds have a poor risk-return profile for most investors.

Before the euro, successful companies in countries with weak currencies still had to pay high interest rates. On the other hand, less efficient firms in nations with stable currencies enjoyed relatively low interest rates. The primary risk in lending across borders was the currency risk, instead of default risk. With the euro, investors in low interest rate countries, such as Germany and the Netherlands, were able to lend money to firms in other eurozone countries without currency risk.

Mutual Support

In theory, the euro should help countries that adopt it to support each other during a crisis. The currencies of countries with larger economies tend to be more stable because they can spread risk more effectively. For example, even a prosperous small Caribbean country can be devastated by a hurricane. On the other hand, the U.S. state of Florida can turn to the rest of the United States to help rebuild after a hurricane. As a result, the U.S. dollar is one of the most stable currencies in the world.

The coronavirus crisis tested mutual support within the eurozone in 2020. Initially, there was not enough collective action. Even worse, many nations closed their borders to each other. However, the European Central Bank consistently bought up enough debt in afflicted countries, especially Italy, to keep interest rates relatively low. More importantly, France and Germany supported a recovery fund worth over 500 billion euros.

Cons

Rigid Monetary Policy

By far, the largest drawback of the euro is a single monetary policy that often does not fit local economic conditions. It is common for parts of the EU to be prospering, with high growth and low unemployment. In contrast, others suffer from prolonged economic downturns and high unemployment.

The classic Keynesian solutions for these problems are entirely different. The high growth country ought to have high interest rates to prevent inflation, overheating, and an eventual economic crash. The low growth country should lower interest rates to stimulate borrowing. In theory, countries with high unemployment do not need to worry much about inflation because of the availability of the unemployed to produce more goods. Unfortunately, interest rates cannot be simultaneously raised in the high growth country and lowered in the low growth country when they have a single currency like the euro.

In fact, the euro caused precisely the opposite of standard economic policy to be implemented during the European sovereign debt crisis. As growth slowed and unemployment increased in countries like Italy and Greece, investors feared for their solvency, driving up interest rates. Typically, there would be no solvency fears for governments under a fiat money regime because the national government could order the central bank to print more money.

However, the European Central Bank's independence meant printing money was not an option for eurozone governments. Higher interest rates increased unemployment and even caused deflation and negative economic growth in some countries. It would be fair to say that the euro contributed to an economic depression in Greece.

Possible Bias in Favor of Germany

The first stage of the euro was the European exchange rate mechanism (ERM), under which prospective future members of the eurozone fixed their exchange rates to the German mark. Germany has the largest economy in the eurozone and had a history of sound monetary policy since World War II. However, pegging exchange rates to the German mark may have created a bias in favor of Germany.

The idea that the euro favors Germany is politically controversial, but there is some support for it.

In the 1990s, Germany pursued a looser monetary policy to deal with the burdens of reunification. As a result, the strong U.K. economy of that era experienced excessive inflation. The U.K. was first forced to raise interest rates and eventually pushed out of the ERM on Black Wednesday in 1992.

The German economy was relatively prosperous by 2012, and European monetary policy was far too tight for weaker economies. Portugal, Italy, Ireland, Greece, and Spain all faced high debt, high interest rates, and high unemployment. This time, monetary policy was too tight rather than too loose. The only constant was that the euro continued to work in favor of Germany.