Saturday, November 24, 2007

Denmark to Join EMU?

After the centre-right Danish government was re-elected with the support of nationalist Danish People's Party, it is now proposing a new referendum on having Denmark adopt the euro as currency.

If the alternative is for Denmark to keep its current currency policy of pegging the Danish krone to the euro, then certainly it makes sense to go all the way and adopt the euro. Denmark's monetary policy is already determined by the ECB and both exchange rates and interest rates follow the euro area so the only difference would be that transaction costs would be eliminated.

The Danish People's Party which opposes the move argues that as Denmark's economy is strong there is no reason for this move. But aside from the fact that Denmark's economy actually isn't that strong with economic growth being among the lowest in Europe, there is no theoretical basis for believing the current peg is superior to joining the euro outright. Or does the Danish People's Party believe that extra transaction costs are good for the economy?

Only if the alternative to joining the euro is adopting floating exchange rates could a case be made against it under the condition that with a floating exchange rate one would pursue a significantly sounder monetary policy than the ECB. In that case it is possible that the reduced distortions from inflation would outweighs the loss from reduced trade that the existence of separate currencies. If however independent monetary policy would be less sound, as sound or only slightly sounder, then a monetary union is superior.

Yet with its current policy of having a peg to the euro, this potential argument against joining the monetary union is inapplicable. Although the peg reduces some of the negative aspects of having a separate currency, it also makes the potential argument for it inapplicable. We are therefore left with only negative aspects -although again these negative aspects are smaller than with a floating exchange rate- of having a separate currency.

Some in Sweden speculate that if Denmark adopts the euro, then that would make it harder for Sweden to stay out. Actually, the effect would be very small for Sweden. Because of the peg, exchange rate movements would be the same if Denmark adopted the euro as they are now. The only economic difference would be that the euro's international status would be slightly higher and that the transaction cost argument would be somewhat stronger as a euro entry for Sweden would then eliminate transaction costs with Denmark as well as the current euro area countries, instead of just the current euro area countries. But that would be a very small difference. The main difference would be that the psychological appeal of euro entry would strengthen if Denmark joined.

The economic case for Sweden joining euro used to be strong with both the trade factor and economic soundness factor arguing for it. Yet with the Riksbank becoming a lot more hawkish and the ECB becoming more dovish in recent months, the economic soundness argument is no longer valid as an argument for joining the euro. To the extent it is applicable, it is an argument against it.


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