What is the purpose of the euro?

Based on their speeches and actions, I doubt that even the eurozone's leaders could properly answer this question. This confusion could soon lead to some unfortunate results. The purpose of the euro is to provide a common currency throughout Europe. That is all that it does. There is no need for fiscal integration or any other sort of oversight or control. Europe's countries are small, and since they are all on the same continent together, they have all been involved in trade with one another for a long time. Greece has a population of only 10 million, less than Los Angeles. Denmark has half of that, at 5.5 million, which is about the same as Miami. Can you imagine if Los Angeles or Miami had its own currency, which floated independently of the dollar? With its own central bank policy board, interest rate policy target and so forth? This would cause endless difficulties for anyone in Los Angeles who wanted to do business with anyone outside of Los Angeles. Eventually, businessmen might say: Let's dump the Los Angeles peso and just use the dollar, like everyone else. This would be particularly true if the Los Angeles peso had a poor history of currency decline, and thus the interest rates on L.A. peso-denominated debt was very high, compared to U.S. dollar debt. Businessmen would wonder: Why am I paying 15% on my peso loan, when people in Texas can borrow at 6%? Thus, Europe's countries have always been drawn toward an arrangement that, at the very least, provides fixed exchange rates between currencies. Most of the time, this was accomplished with a gold standard system. When all the currencies are pegged to gold, then of course their exchange rates with each other are stable and unchanging. Later, this was attempted through various agreements such as the European Exchange Rate Mechanism. But these were rather poor kludges, so they eventually landed on the idea of simply using one currency throughout the continent. This seemed like a foolproof system: There would be no exchange rates at all, so nobody could mess it up.

However, fools are often underestimated. For some reason, they love to overcomplicate this very simple idea. For example, let's take the most recent situation with Greece's central government. Let's say that Greece's government defaults on its debt. So what? All this means is that some people won't get the payment that they were expecting. What does this have to do with the euro? The answer should be: nothing. And what if the governments of Portugal, Ireland, Spain and so forth also default and restructure their debt? This just means that they reorganize their schedule of promised payments. The crux of the problem seems to be this: If a government defaults, possibly leading also to bank insolvency, people are afraid that the value of the euro will decline. This is a rational fear, because apparently nobody told the fools in charge of the euro how to actually manage the currency they created. They seem to think that it is mostly a matter of making carefully worded statements in press conferences. Unfortunately, as they have already discovered, this wishing-and-hoping-and-lying technique is really not very effective. However, it is in fact very easy to support the euro's value, if there was a tendency for it to fall. You simply reduce the number of euros in existence: The ECB would sell euro debt, take euros in return, and make them disappear. If you like, you could even sell dollar debt, then sell the dollars in the foreign exchange market and buy euros, and make those euros disappear. Either way, if you reduce the supply of euros, then the euro's value would be supported. This would have to be an "unsterilized" adjustment, to use the rather strange terminology common today. Once we see that the ECB can effectively support the euro's value, then it does not matter whether this government or that defaults. Default away! This is how capitalism is supposed to work. The euro is supposed to be a common currency in which people can do business. Sometimes, business involves default. It's not supposed to be any more complicated than that.

What if the city government of Los Angeles defaulted on its debt--as may in fact happen soon? Would that mean that Los Angeles should then abandon the U.S. dollar, and issue a Los Angeles peso? It is as if the solution to a default involves dousing yourself in gasoline and lighting yourself on fire. May I suggest that this is perhaps a bad idea. Over time, the eurozone leaders might discover that, although the euro facilitates trade by providing a common currency, that alone does not guarantee currency stability. The euro's value might rise or fall, with major economic effects. Eventually, they might rediscover why Europe always used gold as their monetary foundation. Gold is stable in value, so if you link your currency to gold, the currency is also stable in value. This is much better than hoping the present collection of bureaucratic mediocrities will somehow get it right, by dumb luck. Once the decision is made to link to gold, the ECB would use the same technique as before: if the euro's value is too low compared to its gold parity, then the euro base money supply is contracted. If the value is too high, the euro base money supply is expanded. This is a mechanism identical to today's currency boards, which is why I say that a gold standard system is like a "currency board linked to gold." It is also the effective mechanism by which gold standard systems have operated in the past, throughout Europe. A common currency should be the simplest thing in the world. The euro has no "inherent problems," except for the incompetence of its managers. Once they learn how to do their jobs correctly, the fiscal situation of Greece, Portugal, et. al., becomes irrelevant. Power of euro as an international currency The myriad benefits of the euro in the global economy arise from the size of the euro area, the integration of its economy, as well as its clear, joint commitment to sound economic policies. This makes the euro an attractive currency for other countries and trading blocs in the global economy. The euro is now the second most important world currency after the US dollar. Supporting international trade

As the worlds largest trading power, with an open economy and a stable currency, the euro area is an attractive destination for other trading nations. Third-country companies are therefore increasingly willing to do business in euro. This means that when euro-area firms export or import goods they can invoice and pay in euro reducing their costs and the risk of losses caused by global currency fluctuations. Thus, overall, the euro facilitates and encourages trade with the rest of the world. Foreign appeal The euro is also attractive to foreign governments as a reserve currency because of its strength and the confidence it inspires. In this way, they can spread the risks to their foreign exchange reserves by holding euro as well as US dollars and other currencies. This is of benefit to the euro-area economy because widespread holdings and a high demand for euro encourages third countries to price their exports in euro thus reducing costs to euro-area members because there are no exchange rate costs. In addition, since the euro is in demand internationally, government borrowing by euro-area members on international markets is less expensive because there is more competition to accept euro in debt repayment. The share of the euro in global foreign exchange reserves has risen from 18% in 1999 to over 25% in 2007. The most significant increase can be found in developing countries, where holdings are now close to 29%, from 18% held in 1999. One currency with one voice The international financial institutions, such as the International Monetary Fund (IMF), the World Bank and the Organisation for Economic Co-operation and Development (OECD), increasingly view the euro-area economy as a whole when dealing with macroeconomic matters. They do this because the strength of the euro, the size of the euro area as a trading bloc, and the coordination of policy-making within the euro area, all mean that what happens in the euro area has growing spillover effects on the world economy. This growing impact on the world economy is matched by a growing influence of the euro area within these international financial institutions. This gives the European Union a stronger voice in the world.

The euro area: key indicators (2006)

Euro area Population (millions) GDP (in trillions calculated at purchasing power parity) Share of world GDP (% at PPP) Exports(* ) (goods and services as % of GDP) Imports(* ) (goods and services as % of GDP)
(* ) Excluding intra-EU trade Source: European Commission, ECB and IMF data 2007

EU27 494 11.9 21.0 14.3 15.0

US

Japan

317 8.4 14.6 21.7 20.9

300 128 11.2 3.5 19.7 6.3 10.8 16.8 16.6 15.3

Easier, safer, and cheaper borrowing Low inflation and stable prices are a key aim of the management of the euro-area economy. Because the European Central Bank acts to keep inflation low, interest rates are also lower. This means consumer loans are cheaper and future repayments are more predictable, so ordinary citizens can borrow more easily and cheaply, for example to pay for holidays or to buy a house. Mortgage rates have fallen from around 8%-14% in the early 1980s to an average of 5% now in the euro area, saving a borrower with a 100 000 outstanding loan between 170 and 750 a month on interest payments.

More growth and jobs In a single market with a single currency, doing business across borders is cheaper for companies as they no longer need to include the risk of currency fluctuations into their prices nor to pay exchange costs. Previously, these costs amounted to around 20 to 25 billion annually within the European Union. Today, they have disappeared in the euro area. This helps release capital to invest in expanding and growing business and employing more workers, thereby benefiting jobseekers and their families. Since the euro was introduced in 1999, more than 10 million new jobs have been created in the euro area, compared with only 1.5 million in the previous seven years. The euro is increasingly used to issue government and corporate debt worldwide. At the end of 2006, the share of the euro in international debt markets was around one-third, while the US dollar accounted for 44%. Global banks make significant loans denominated in euro around the world. The euro is the second most actively traded currency in foreign exchange markets; it is a counterpart in around 40% of the daily transactions. The euro is extensively used for invoicing and paying in international trade, not only between the euro area and third countries but also, to a lesser extent, between third countries. The euro is widely used, alongside the US dollar, as an important reserve currency to hold for monetary emergencies. At the end of 2006, more than one-quarter of the global foreign exchange holdings were being held in euros, compared to 18% in 1999. Developing countries are among those which have increased their reserves in euro the most, from 18% in 1999 to around 30% in 2006. Several countries manage their currencies by linking them to the euro, which acts as an anchor or reference currency.