Ifo Viewpoint No. 31: The True Significance of the Euro
30 April 2002
The introduction of the euro was a necessary step in the political evolution of Europe. What, however, is the true significance of the euro for the economic development of the Continent and its regions? The ability to compare prices more easily and the elimination of currency exchange costs are obvious, but secondary, benefits.
By far the most important implication of the euro is the creation of a common European capital market freed from the barriers which were created by exchange rate uncertainty. As recently as 1995, yields on long-term government bonds in Italy or Spain were five to six percentage points higher than in Germany because international investors demanded high risk premia, and it was similar in other countries. Only Austria and the Netherlands had the same low yields as Germany. With the announcement and introduction of the euro, interest rates have converged almost completely.
As a consequence, the profitability requirement that real investments must satisfy is identical everywhere in Europe, and firms in peripheral countries can now receive loans at the same favourable conditions once enjoyed by German, Austrian and Dutch firms alone. This will lead to an investment boom in the southern and peripheral countries of Europe that will be reflected in an increase in the aggregate European growth rate. With the creation of a unified capital market, convergence in Europe will be accelerated and a sustainable growth stimulus will be created that could last a decade or longer.
For Germany, however, the implications are ambivalent. Presumably, Germany will continue to have the lowest GDP growth rates in Europe, among other things because of the euro. Whether this is an absolute or only a relative growth disadvantage is not clear. Currently interest rates are still so low that it is not possible to see any absolute disadvantages for Germany stemming from improvements in the situation of other countries. However, the high capital demand in the countries freed from risk premia could lift German interest rates to levels that would not have been reached without the currency union. This would indeed be an absolute growth disadvantage. This result is even relatively probable, considering that the euro has flexible exchange rates with the rest of the world, thus separating the international capital markets to some extent.
Caution is in order, however, in evaluating this development as there are winners and losers in Germany. It can indeed be assumed that the factors of production that are complementary to the factor capital, and this is especially the factor labour, will be among the losers. With the slowdown of capital accumulation, labour productivity increases more slowly, and the scope for employment-neutral wage hikes narrows. In contrast, German savers, financial investors and real investors can safely shift their capital into formerly high-interest-rate countries and earn much higher returns than at home. Presumably the gains of the winners will more than compensate for the losses of the losers, as is usually the case when free trade is established. A possible result is that Germans on average will also earn more income, although the majority of Germans will belong to the losers.
The euro together with the fall of the Iron Curtain, which created low-wage competition at Germany’s doorstep, have worsened Germany’s competitive position. It can no longer be taken for granted that the German economy, backed by the privilege of an unrivalled stable currency, will remain the engine of European economic growth. Which makes it all the more urgent to overcome barriers to reform in education and on the labour market that also reduce competitiveness. The omissions and mistakes of the past, that up to now have been offset by other advantages, are becoming all the more evident and call for a courageous turnaround in economic policy.
Professor of Economics and Public Finance
President of the Ifo Institute
German original published in an extended version as "Was der Euro wirklich bedeutet" in "Akademie Aktuell", published by Bayerische Akademie der Wissenschaften (1/2002, April 2002).