Why The Euro Gained Primacy

Since its launch in 1999 as accounting currency and distribution as physical coins and banknotes just five years ago, the euro has appreciated against the U.S. dollar, become the currency of choice for international financing instruments, and grew to be the second most actively-traded currency, after the U.S. dollar, in forex markets. It is not enough for detractors to claim that sheer force of habit by a continent-wide mass of people has kept the euro prominent. The vitality of the euro zone economies, development of more sophisticated financial intermediaries and greater liquidity are equally important.

The tremendous size, diversity, dynamism and openness of the Common Market economies invite equally brisk trade and significant capital inflows. Given a population that is at least 50% bigger than that of the U.S.A., gross domestic product at least as large and managed in open, democratic fashion, the EU can obviously wield great economic influence on a global scale.

True, recent economic growth has been diluted somewhat by counting the accession nations and others waiting in the wings. Compared to economic growth that averaged 5.7% in the rest of the world, the euro zone was positively sluggish in typically expanding at just over 1% over 2003 to 2005.

The influence of the euro can only continue to grow, however, as the EC countries individually and collectively strive for structural reforms, reduce or take down subsidies, otherwise improve productivity, and rein in fiscal deficits.

Secondly, more predictable price levels in the EU countries and a fairly steady exchange rate reduces intermediation costs and risk. Financial markets can accept euro-denominated debt instruments with greater confidence on what the conversion and payoff outcomes will be months or years down the road. Political will exercised by the member-countries aside, the terms of the Maastricht Treaty did empower the European Central Bank (ECB) with the autonomy and authority to keep inflation in check. The record of the ECB in this respect has been enviable. Inflation has been manageably low and the exchange rate of the euro has, except in recent weeks when appreciation was the norm, stayed within very narrow bands.

Yet a third factor that explains the current preeminence of the euro is the diversification and integration of financial markets on the continent.

Long-running enmities die hard. Compared to the U.S. experience, banks historically monopolized financial markets in the euro zone. And before the Common Market and currency integration came into being, the financial sector in each country was more prone to compete, rather than cooperate, with cross-border rivals.

Since the mid-1980s, however, financial systems have evolved and become more sophisticated. The adoption of the euro and, in 2000, the Financial Services Action Plan (FSAP) were important milestones. Specifically, the FSAP bound the member-countries to eliminate regulatory and market barriers. Providing and accessing financial services regardless of national borders induced the free flow of capital and, by racheting up competition, introduced more efficient financial markets.

Concretely, the favorable developments have included more liquid bond markets, a narrower range of sovereign interest rates, and financial instruments that became more creative but also more complex. The stock markets have also benefited. Investors seem better-prepared to focus on company and industry news rather than on how market sentiment or political economy differ country by country. There is greater consistency in stock prices across the major bourses and EC-wide funds have gained a better equity markets.

All in all, the current strength of the euro can be attributed to the great size, industrialization and openness of the Common Market itself, as well as stable prices, intermediation costs and exchange rates.