Small Countries and European Monetary Integration

Embassy of Finland
Washington 9.3.2000

Let me start by thanking the Finnish embassy for this opportunity to discuss with you recent developments in European monetary integration. The profound changes taking place in Europe have already had implications worldwide, also here in the US. It is an honor to share my views with such a distinguished audience.

In the beginning of 1999 eleven member states of the European Union took the crucial step to replace their national currencies by a single European currency, the euro. For more than a year, these countries have shared a single monetary and exchange rate policy, run by a new independent central bank, the ECB.

Euros are already used extensively in trade, and in some parts of the financial markets. A large interbank market has been created in the euro area. Government bond markets have become more integrated. Corporate restructuring has been an important factor behind the growth in private euro-denominated bond markets.

There are four EU countries that are outside the European Monetary Union. It is indeed an interesting question, why these countries, particularly the small ones, have adopted such different approaches towards EMU.

Is an independent monetary policy possible?

In the ongoing discussion, one basic question has been to what extent an independent monetary and exchange rate policy is still possible for small countries. Exchange rates and interest rates matter, but individual countries face nowadays much harder monetary policy constraints than before, regardless of whether or not they participate in EMU.

In many countries, including Finland, there has been a feeling that the freedom to devalue a national currency was misused in the post-war period. According to this view, exchange rate changes are quickly transmitted to prices and wages. Devaluations, therefore, do not lead to permanent improvements in the competitive
position of the country, and do not solve any structural problems. Instead, they only lead to higher inflation.

As to the history of small European countries, I do not share this view. In the past, the possibility to devalue the national currency has often helped to avoid and shorten recessions.

I have recently written a book on the Finnish great depression of the early 1990s with Dr. Kiander, who also sits here with you. In our book we argue that in the past it was often useful for Finland to be able to come out of deflationary situations by devaluing the Finnish markka. Undoubtedly, there will be cases also in the future where the possibility for an independent exchange rate and monetary policy would be valuable.

However, both of us were in favor of Finland’s membership in the European monetary union. In a world with globalizing financial markets, it is more and more difficult for national authorities to conduct independent monetary policies. The debate over the relative merits of fixed and flexible exchange rates will undoubtedly
continue, but we believe that for small European countries the benefits from the monetary union will gradually outweigh the value of national monetary autonomy.

What are the benefits of the monetary union?

First of all, it must be emphasized that the introduction of the euro was an important political event. The single currency strengthens cohesion between participating countries through various economic and social channels. The political will to increase cohesion in Europe was an important reason for the establishment of the monetary union.

It has been pointed out, also from the US side, that the euro area as such is not an optimal currency area. Production structures differ much between countries, mobility of labor is lower than between the US states, and there are no fiscal transfers between EMU countries.

Production structures in European economies differ from the average production structure in the EU. In particular, the small countries typically differ from the average. This increases the risk of so-called country specific shocks, which cannot be overcome by the general monetary policies of the European Central Bank.These structural differences have been an important argument against the monetary union.

On the other hand, many Europeans see EMU as a method to put pressure on European institutions and as a way to a stronger Europe. According to this idea, EMU may solve some problems related, for example, to inflexible labor markets. This kind of forced undertaking, of course, also has its risks. EMU alone is not sufficient to make Europe a dynamic economy it needs to be supported by measures to eliminate structural rigidities in labor and product markets.

The euro has eliminated exchange rate uncertainties between participating countries and some of the costs of international trade. A major barrier to free trade in the European Single Market has thus been removed and an opportunity has been given to firms to benefit from economies of scale in the enlarged domestic market.

The single currency also means that some exchange rate uncertainties are reduced for countries outside the euro area. It is now simpler, for example, for US firms to trade with Europe than before the monetary union.

The single currency, especially after the introduction of euro notes, will enhance the transparency of prices. This will lead to increased competition, cheaper commodities and services, and higher real incomes.

A few years ago some very interesting studies on the effect of the currency border on prices in US and Canadian regions were published in the American Economic Review. It is intuitively clear that prices differ more in regions that are far away from each other than in regions located closer to each other. The US-Canadian currency border was estimated to increase the distance between regions by close to 2000 miles. The dismantling of several currency borders in Europe will thus increase the transparency of prices, and competition, in a significant way.

A better functioning European Single Market is particularly important to small countries, which are very dependent on the international division of labor. Let us again take an example from Finland. Large Finnish companies have to be very international, because the domestic market is simply too small.

In recent decades, Finnish firms have rapidly increased their production facilities in other countries. This table shows that more than half of the employees of the large manufacturing companies are employed outside of Finland. Two-thirds of the capacity outside Finland is in other EU countries. Recently there have been mergers and acquisitions also with North American companies. For example, UPM-Kymmene
merged with Champion and Stora-Enso bought Consolidated Paper.

It is also worth mentioning that foreign ownership in Finland has increased rapidly. Half of the owners of many Finnish companies are typically non-Finnish. In the case of Nokia, foreign ownership is more than 80 %.

Since the euro area represents an economic area equal to that of the United States, the euro will become influential also internationally. In the longer run, it will compete with the US dollar for the position as the world’s dominating currency.

Countries trading with the EU are gradually beginning to use the euro in international trade, especially Central and Eastern European countries. The US dollar may still be preferred as a means of payment for European imports from the United States and also for trade in certain raw materials.

The primary objective of the European Central Bank, is the maintenance of price stability. In practice, price stability is defined as an inflation rate below 2 percent. This increases the potential for the euro to play a role as an international reserve currency.

These benefits are particularly important to the small countries, which earlier were not able to use their own currencies in international transactions. Small countries typically conduct trade in so-called vehicle currencies, like the dollar, or in the currencies of larger countries. The share of Finnish foreign trade conducted in Finnish markka used to be only about one fifth. From this table we can see that, for example, 20 % of our exports was invoiced in dollars in the middle of the 1990s. From now on Finnish foreign trade will be conducted mostly with our own currency.

As to price stability and low inflation rates, they would be much more difficult to achieve outside EMU because Finland does not have such a record of stability-oriented policies as does, for example, Germany.

The EMU situation at the moment

These arguments for and against the monetary union are well known and they have been widely discussed for many years.

Let us now have a look at the map and see what kind of choices various European countries have made so far. The eleven EMU countries have been colored dark blue in the map.

France and Germany were both necessary members for the monetary union to be established at all. Likewise, The Netherlands, Belgium and Luxembourg are among the core countries, which started the European integration process after the Second World War, and it is quite natural that they also participate in the monetary union. Austria has traditionally had very strong economic and social linkages with the core
countries, particularly with Germany, and this led it to choose the monetary union.

Italy wanted strongly to get in, even if it had some problems meeting the criteria, which related to inflation, interest rates and the reduction of public deficits in the years leading up to the monetary union. Italy has benefited much from the decline in interest rates, which it has enjoyed as a result of its membership. Out of all the Southern European EU countries, only Greece is outside. It did not fulfill the convergence criteria. Greece has recently expressed its willingness to join the EMU soon.

In Northern Europe the situation is divided. The United Kingdom is the only large country outside of EMU. The Blair government has laid out five economic tests, which will determine when the conditions are ripe for an entry. However, at the moment sterling is expensive and it is difficult to say what will happen in the next few years.

Ireland is a good example of the problems created by the single monetary policy. The present interest rates set by the European Central Bank are not high enough for Ireland. Most of the EMU area is still coming out of a recession, but the Irish economy is already overheated. The Irish now have to cool down their economy with domestic policies. The main instrument for controlling domestic demand in this kind of situation is tight fiscal policy.

A crucial element in the stabilization of all individual countries is the matching of national wage and productivity developments. Wage increases should also support profitability, employment and investments.

The situation in the Nordic countries is an example of how apparently similar countries have chosen different the European Economic Area, but it had a referendum in 1994 and decided to stay outside the European Union. Thus it cannot be a member of EMU. Denmark is a member of the EU, but opted out of the monetary union from the very beginning. Finland and Sweden also had a referendum on EU membership in 1994 and decided to join. Finland is now also a member of EMU, but Sweden decided to stay outside.

It is difficult to find good reasons why these two neighboring countries with similar post-war economic histories and similar structures have made a different choice with respect to monetary union. For the Swedes the deep recession in the beginning of the 1990s became an example of country-specific shocks, which can be overcome by national monetary freedom. For Finland, the same experience became an example of how difficult it is to conduct independent policies outside the monetary union.

An important factor behind the stance towards the monetary union is the feelings of the population towards the EU in general. This figure shows how citizens answer the question, has membership in the EU benefited your country. The answers clearly correspond with the stance that these countries have adopted towards EMU. Southern European countries have benefited much from the direct EU transfers and this is also
known by the population. These countries are also members of EMU or, like Greece, they want to join. The most negative answers are found in Sweden and the UK, which have also stayed outside of EMU.

The map also shows the accession countries, most of which are very small. Many of them have expressed their willingness to also join EMU. Eastern enlargement of the European Union and also gradually of EMU will be a long and difficult process. Even in the most successful case, it will take a long time before all these countries can share a single European currency. There are more than 30 countries with great cultural and
institutional differences on this map. Rapid enlargement of the monetary union to include a large group of heterogeneous countries would be a great risk for the EMU project.

The recent weakness of the euro

There was much discussion on the potential strength of the euro already before it was created. It has been generally recognized that there still is an underlying tendency for the euro to appreciate vis-a-vis the US dollar and the Japanese yen in the years to come.

Contrary to what many of us expected, the euro has been rather weak. However, the euro is not weak because of structural reasons related to the credibility of the currency. In the short run, it is the general economic developments and stance of monetary policies in the euro area relative to those in the United States that determine the value of the euro vis-a-vis the dollar. Thus, the euro has been weak because very
good economic developments in the US and the interest rate differential have strengthened the dollar.

This figure also shows that, even if the euro has weakened, it is still not outside historical variation levels. The weakening is thus not a very dramatic event. Furthermore, an internationally weak euro has been a hard currency internally, because price stability has been maintained in the euro area.

The current situation in the US economy

At this moment I cannot resist the temptation to comment shortly on the present situation in the US economy.

The American current account deficit is so large that the dollar is very likely to start weakening and the euroappreciating – sooner or later. To solve this imbalance smoothly, it would be better to start this process sooner.

The recent developments in the US are very similar to what happened in some European countries in the beginning of the 1990s. Overheated economies were supported by large inflows of capital, which more than compensated the large structural current account deficits. There was thus continuous pressure for the
currency to appreciate. This finally led to several exchange rate depreciations and the collapse of the whole European Monetary System in the fall of 1992.

It is easy to find other similarities between the present situation in the US and the European crisis countries in the beginning of the 1990s. Not only current account deficits, but also asset price booms, increasing indebtedness, and a positive outlook for government tax receipts caused by the good times were all experienced in Sweden and Finland. Both these countries later experienced a deep recession with balance
sheet problems and a banking crisis, similar to the crises in Asia some years ago.

There has been extensive discussion about whether the US has entered a period called the New Economy. This discussion is very interesting, but it should not overlook the fundamental macroeconomic disequilibrium threatening the US economy.

The recent report by the Council of Economic Advisers included an excellent chapter on the global economy, explaining how also the US has become more open to trade and capital flows. Globalization has certainly benefited the US in many ways. However, it has also made the US more vulnerable. In this respect the difference between large and small countries is disappearing.

A soft landing in the US is very important to Europe. Many European countries are just coming out of a slow growth period and have not yet reached balanced budgets. For the success of the EMU project it would be important that there is room for the so-called automatic stabilizers to work in the next recession. Otherwise, fiscal policies have to be tightened in a recession, which would be politically very difficult.

The consolidation of public finances is important also, because the aging population will put great pressure on the European pension systems in the longer run. There was an interesting article on this problem called Can EMU survive in the latest issue of Foreign Affairs by Ferguson and Kottlikoff.

Comparing various historical crises with each other and with the current situation is a fascinating subject, one that would make a good theme for another seminar. We have to leave that topic, but let me remind you that the turmoil experienced in the European financial markets in the fall of 1992 led many economists to doubt the benefits of the monetary union. Many also thought that the timetable set for EMU at that time would not hold. In less than ten years, with a more favorable environment, and with the success of the EMU project, the views of many economists have gradually changed.


Even if the establishment of the monetary union has already had strong effects on national institutions, ordinary citizens in the EMU countries have not yet lived through the changeover to the use of euros. We have seen euro prices in shops and in financial markets. Bank accounts are expressed in markkas and euros but national currencies are still used in the majority of transactions. The final completion of EMU will take place in the beginning of the year 2002, when euro notes and coins will be introduced. For some months euros and national currencies will exist together. After that, 300 million Europeans will lose their beloved national coins and banknotes with various national symbols, very likely forever.

I have defended the view that in a world of globalized financial markets the benefits for small countries from the European Monetary Union exceed the diminishing benefits from national monetary autonomy.

The short-term economic outlook for the euro area, as well as for the EMU project, is favourable. However, one year is certainly too short a period to make any definitive assessment on the performance of the monetary union.

EMU has been characterized as a unique experiment, which has not yet been tested. However, the failure of EMU would be extremely costly economically and politically, and having already been started, a consensus has been reached that it must not fail.

It is a risky venture, but we have to remember that it also provides an opportunity to increase prosperity in Europe. Anyway, the enlargement of the European Union will keep the discussion on small countries and European monetary integration on the agenda for many years to come.