Threats of an Economic Cold War: Understanding the Global Effects of the New European Economic Union’s Currency

 

By Dod E. Wales, Blake Holden Zac Moffatt

 

The Euro is a remarkable concept.  A currency for the age of computers, of mobile capital, of business trumping government, the place where power resides. From the Atlantic coast of Ireland to the Russian-Finnish border, clear down to the Greek ruins in Sicily, there will be one currency.  Back in the days of empires and hard money, maybe that wasn't such a big deal. Wealth lived in hard metal and specie. The European ruler or mythical figure staring from the coin's face didn't matter all that much, as long as it was true gold.  But in the days of fiat money, hooking up Corsica to Nice, Hamburg to Barcelona, Helsinki to Antwerp in such a stunning way, is an awesome concept.

            On this side of the Atlantic, it might be hard to see why.  Our habits of mind are shaped by 200-plus years of a constant, stable currency. A traveler from Portland, Maine, can drop a 20 dollar bill, earned back at home, on a store counter in Portland, Oregon, and so what?  There may be vastly different home prices, prevailing wages, tax levels, and a lot of other economic variables between the two cities, but those differences are, for a moment, erased by Andrew Jackson’s image staring up from the bill.

            The decision to launch a single currency is perhaps the boldest move in the history of the European Union.  It will be a powerful signal of European countries' determination to forge ever-closer political and economic integration. Countries that have in the recent past, fiercely guarded their independence, and indeed within living memory have been at war with one another, will share one currency, that most potent symbol of nationhood.  The launch of the single currency cannot be understood without this political backdrop. 

            Eleven countries are likely to join EMU at the outset.  These include some of the world's most advanced industrial economies. They will create an economic unit close in size to that of the United States.  The population of the EMU area will number 290 million, compared with 265 million in the United States. In 1997 the GDP of the EMU area was $6.3 trillion, compared with $8.1 trillion in the United States.  According to the European Commission, the EMU area will account for 18.6% of world trade compared with the United States' share of 16.6%.

General Background

Over 130 years ago France set up a Latin Monetary Union, that embraced Belgium, Italy, Switzerland, Bulgaria and Greece.  This monetary union did not last, but Europe did not give up on the idea of permanently securing currency stability.  For much of the 20th century European currencies were fixed, first to the gold standard and later as part of the Bretton Woods system of fixed exchange rates.  But even within an international system of pegged exchange rates, many Europeans sought greater currency union.  In 1962 the European Commission, the central secretariat of the European Economic Community (as the European Union was then known), proposed the creation of a single European currency. In 1970 European heads of government approved a document, called the Werner Report, that suggested introducing a single currency by 1980.

            After the international system of fixed exchange rates fell apart in the early 1970s, Europeans tried alternative systems of currency stability.  They created a mechanism, called the "snake in the tunnel", through which Europe's currencies would be tied to the Deutschmark.  This "snake" had many problems.  Britain joined in May 1972 and left soon afterwards.  France and Italy joined and left more than once.  In these cases domestic policy concerns proved incompatible with maintaining an exchange-rate peg.

            In 1978 the Europeans tried a new tack.  They created the European Monetary System, and as part of this, set up a formal exchange-rate mechanism (ERM) to limit currency fluctuations. Member countries committed themselves to ensuring that their currencies remained within a narrow band around a central rate that was determined in "ECU", a unit of account comprised of a weighted basket of European currencies.  But here too there were problems: some countries, such as France, repeatedly devalued their currency within the ERM.

            Unhappy with the inadequacies of the ERM and determined to foster ever-greater economic integration among European countries, the European heads of government commissioned, in June 1988, the Delors Report on the creation of a single currency.  This report formed the intellectual basis of a process that culminated in the Maastricht conference of 1991, where the members of the European Union committed themselves to a clear timetable for monetary union and agreed upon the conditions of its operation.  Britain, and later Denmark, negotiated an opt-out.

 

The Maastricht Treaty

            The Maastricht Treaty set a definite date of 1999 for the launch of the new currency. However, more important, it laid out in great detail the conditions a country would need to fulfill in order to be eligible for entry. Officially, these Maastricht conditions were designed to ensure that those countries that entered into a single currency would be able to live with it economically.

            The Maastricht Treaty stipulated that to be eligible for joining EMU, a country must have an independent central bank. Its currency must be a member of the European exchange-rate mechanism, and must have remained within the "bands" permitted by the ERM for at least two years.  Most important, certain macroeconomic criteria had to be met.  These have become to be known as the Maastricht convergence criteria.  To be eligible for EMU:

-    A country's average inflation rate over the past year must not     exceed that of the three lowest-inflation countries by more than 1.5 percentage points.

            -    A country's average long term nominal interest rate, over the past

year, must not exceed by more than 2 percentage points that of the three countries with the lowest inflation.

            -    A country's budget deficit must not exceed 3% of GDP

            -     A country's ratio of government debt to GDP must not exceed 60%.

 

The idea behind these criteria, particularly the fiscal criteria, was to keep EMU small by setting tough standards that--at the beginning of the 1990s--looked certain to keep out profligate Mediterranean countries, such as Italy and Spain.

            In a further attempt to ensure that participating countries would be fiscally prudent, the Maastricht treaty set limits on Euro member countries' future budget deficits.  At the insistence of Germany, this part of the treaty was further stiffened in 1996 in the "Stability and Growth Pact".  This pact permanently limits EMU member countries to budget deficits of no more than 3% of GDP, and threatens any country that exceeds them more than temporarily with heavy fines.

            From January 1st 1999 monetary policy in the Euro-area is determined by the new European Central Bank, based in Frankfurt. This institution, modeled in part on the Federal Reserve, is fully independent, and charged with the goal of pursuing price stability.  It has an executive board with a president, vice-president and four to six members, each appointed for eight-year non-renewable terms. A governing council, consisting of the executive board and the central-bank governors of all Euro members will make decisions on monetary policy.  That is a similar structure to the Federal Open Markets Committee, although rather more decentralized. Whereas only five of the 12 voting members of the FOMC come from the Federal Reserve's district branches, the new ECB will have 11 members from its participating countries.  Voting on monetary policy will be by simple majority.  Reflecting this decentralization, the ECB will also have a tiny central staff, of fewer than 500.

            For three years national coins and notes will remain in circulation, although technically they will be mere subdivisions of the Euro.  Actual Euros will be introduced on January 1st 2002, and by July 1st 2002 national notes will cease to be legal tender.  However, the existence of the Euro will be felt long before actual notes appear.  For instance, participating governments have announced that they will issue debt denominated in Euros from January 1st 1999.  Corporate debt in Eurasia and indeed broader corporate accounting in Euros should soon follow.

The Euro’s Impact; A Global Perspective

The incoming Euro is a major step for the European Union; however, it affects a much larger step for many countries around the world.  There are many countries around the world that, because of their ties to the European Union will be forced to change along with the main EU countries.  Most of these countries are bound by colonial ties to a certain country and have based their monetary system off an EU country. 

            Euroland will be the world's biggest economy. Not only will the Euro be the sole currency inside the Euroland eleven, it will quickly become a parallel currency in the rest of the European Union and then across the wider Europe, where many currencies are already pegged to a basket of European currencies.

Africa and the EMU

The largest concentrations of countries in this situation are located in the regions of Africa.  The largest numbers of countries in Africa with ties to the Euro are the CFA countries (African Finance Community).  There are 14 countries in the CFA zone.  All of these countries were pegged to the French Franc.  So now with the introduction of the new currency will force some changes upon these West African nations.

            As announced in the previous issue of European Report, the European Commission proceeded on July 1 to adopt a recommendation upholding the procedures for future relations between the Euro and the CFA Franc and the Comorian Franc. Prepared by the services of Yves-Thibault de Silguy, European Commissioner for Economic and Monetary Affairs, the recommendation says that the present arrangements, under which the French Treasury guarantees conversion at a fixed parity with the French Franc, should not be materially affected by the transition to the Euro. According to the present parities, one French franc 100 CFA francs and 75 Comorian Franc.

            The arrangements with the African countries are independent of the provisions for France and its overseas territories in the Pacific, which use the CFA Franc. Protocol 13 to the Treaty of European Union states that France will retain the privilege of monetary issuance in these territories and will be solely entitled to determine the parity of the CFA Franc. There is, therefore, no need to deal with these arrangements in the present recommendation.

            But the fear that the currency will again lose some of its value has set in CFA zone countries such as the Republic of Congo.  Business people have begun taking precautions in Brazzaville. Last month, commercial banks, for example, registered a sudden spate of withdrawals by depositors, according to the Bank of Agriculture, Industry and Commerce (CAIC) in the Congolese capital.

            In the West African nation of Burkina Faso, people are convinced that a second devaluation of the CFA is inevitable.  There are many others who feel history may well repeat itself. They know it's inevitable that the CFA will be unpegged from the French franc since the Euro will replace the European currencies in 2002. However, the impending devaluation will not be like the first one.  They feel the devaluation coming will be based on the value of the money actually falling, while the last one was based on policy.

            The Central Bank of West African States (BCEAO) has reported that CFA franc has effectively been pegged to the Euro at 655.957 to one Euro.  Officials have also confirmed that the CFA in relation to the French franc remains at 100 CFA to one French Franc.

            Some businessmen in these countries are afraid that joining with the Euro could come back to haunt them.  If the Euro becomes much stronger it could erode the competitiveness of their exports to Europe, which currently accounts for 60 percent of their total trade.  The problem with this is that once the currency is switched over, the African exports and European imports will be much cheaper.  Thus, decreasing the CFA income from exports could harm the countries since it accounts for 60 percent of trade.

            The Euro will also be used in the Mediterranean and North Africa.  These areas are sandwiched between zones that have already committed to the Euro.  Because of the ease in trading between areas using the Euro, the Mediterranean and North Africa will probably be forced to switch to the Euro as well.  Another draw to the Euro has to do with the exchange rate.  If these areas stick with the dollar they will have to pay the extra charges associated with the exchange rates.

            With the addition of the Mediterranean and North Africa most of the continent's trade and investment, money, and debt stocks will be denominated in the new currency.

            While much business between Asia and Europe has been invoiced and settled in one or other of the European currencies, especially the German mark, this will automatically shift to the Euro, as will much of the business now in US dollars.

Part of this is trade with Italy and Spain and other smaller European countries currently transacted in dollars but expected to switch to the Euro soon.

            In addition close neighbors in Eastern Europe and North Africa and Turkey may also turn to the Euro because of the importance of their European trade, leaving sterling, the Swiss franc and the Swedish krona only units for international trade.

            Following suit with the rest of Africa, South Africa may switch from using the dollar in trade transactions to the Euro.  The majority of countries with trading power in Africa will now be adopting the Euro; however, the effects of this are still unclear.  If the Euro becomes powerful the value of some of these African nations could be in jeopardy.  At the same time the Euro could add some much-needed stability to the region.

            The numerous countries affected by the introduction of the Euro have garnered some attention by the United States as well.  Some predict that the dollar could drop as much as 30 percent in the next few years as a result of the strengthening Euro.  Economists have been looking at the switch closely, but there seems to be little interest by the public. 

            But the fact is that if there is no distinctive American attitude toward what could be one of Europe's great achievements, the United States has started looking more at the Euro and its implications.  The Clinton administration approaches Economic and Monetary Union, with a favorable tonality and an official discretion that mask an edge of watchfulness. At the same time, some of the country's most visible economists have taken critical and dismissive positions on its chances of success, warning about the new currency's potential for political friction and economic misery. Business, big and small, looks at it as a positive occasion for rationalizing exchange-rate accounting and trade opportunities. But public opinion thinks of the Euro not at all.

            In a country where confrontation with Iraq, Asian financial disintegration, a swirl of scandal at the White House, and the movement of the Dow Jones average are the hour-to-hour realities of public life, the Euro is of less importance to most.

            All have argued that monetary union in Europe is a mistake. Some see the potential for social unrest arising out of a system, without common budgeting, fiscal policy or flexible labor markets, that with a single currency cannot use exchange-rate variations to rapidly compensate for regional declines. In each case, the economists tend to underrate or disregard the European political will behind the undertaking, and the will of European leaders to sacrifice to make the Euro succeed.

            One economists stated “The EMU has gone from being an improbable and bad idea, to a bad idea that is about to come true, high unemployment, low growth, discomfort with a welfare state that is no longer affordable – all these issues have found new hope for resolution in a desperate bid for a common money, as if that could address the real problems of Europe. On the contrary, the hard work of attaining a common currency... is adding to the burden of an already mismanaged Europe. The struggle to achieve monetary union under the Maastricht formula may be remembered as one of the more useless battles in European history.”

            Of these opinions, the worst case scenario seems to be this. An acceleration of tensions, stressing the inconsistency of a “French aspiration for equality and a German expectation of hegemony.”  The Euro would limit labor-market flexibility and transfer payments, and Europe's competitiveness curtailed.  The global trading system would be undermined as a result, creating the possibility of “serious conflicts with the United States and other trading partners.”

            Some of these economists have even worked out the worst possible situations.  Thorough a downward spiral one felt that conflicts over economic policy and interference with national sovereignty would leave Europe in a situation where war “would be abhorrent but not impossible.”  With the birth of monetary union and a political union that might have interests opposed to those of the United States “the world will be a very different and not necessarily safer place.”

            Some countries, however, don’t feel quite as threatened about the Euro, as the United States seems to.  For obvious reasons Russia is a little out of the loop as far as the introduction of the Euro is concerned.  Russia’s current situation leaves it a little out of the world’s economic picture. 

            Russian officials commented on the introduction of the Euro and had this to say, “Russia is a country that conducts active trade operations with the European Union. For this reason our banking system should be ready for operations with Euro. However, our West European colleagues explain that no dramatic novelties are expected to be introduced in operations with Euro.”

            Therefore, the launching of Euro to us is not an economic policy problem but an operational task, in particular related to managing our reserves.  Operations with the Euro in Russia and in other countries will depend on how convenient they are and to what degree financiers are ready for this.  Russia would not participate "in any form" in operation of the European Union's Central Bank now in formation. 

            Farther down the road, if Russia’s economic woes continue, they might be forced to make some sort of concession in response to the Euro.  Right now the country could not gain entrance to the Euro due to the strict qualifications, but based on the future success of the Euro it might be a possibility in the Russia’s future.

            The Euro is going to change the entire make-up of the world’s economic policy.  By gaining power the Euro effectively moves the world to a bipolar system.  Away from a single economic power system that the United States is enjoying now.  The Euro will gain ground and eat away at the dollar’s 57 percent hold on the world currency.  With the dollar dropping the Yen will become more of a world player as well.  Only time will tell the total effects of the introduction of the Euro, but it’s making a big splash right now.  Many countries are hoping for the best right now, while there are the skeptics that are sitting aside waiting for some results.

European Domestic Incentives for EMU

 

            While it is impossible to understand Europe's desire for a single currency without appreciating the political context of European integration, there are clear economic benefits to be gained from sharing a single currency.  They fall into three broad categories:

            Increased Efficiency.   The existence of single currency removes the transaction        costs involved in switching currencies.  No longer will consumers or businesses need to change money (with attendant costs) every time     they cross borders. More    important, the removal of exchange-rate uncertainty means firms no longer need to hedge against foreign exchange risk.  Given the size of inter- European trade, this is an important benefit.  The investment climate in Europe will become more predictable as the possibility of devaluation is removed.  These efficiency gains are not negligible.  The European Commission has estimated them at 0.5% of European GDP.

            Macroeconomic Stability.  Several European countries have historically been prone             to loose macroeconomic policies and high inflation.  A single monetary policy from an independent central bank that intends to be as credible and anti-inflationary as the Bundesbank will provide these countries with an environment of         stable prices that they could not have achieved alone.  The benefits of low inflation are well known.  But one impact is particularly worth        mentioning.  For those European countries with high levels of public debt, interest payments on public debt are an important component of public spending.  These countries, in particular, stand to benefit from a single currency.

            A more integrated vibrant market.   Beyond the immediate efficiency gains that come from removing currency fluctuations, the single currency may foster greater competition, greater economic integration as well as greater deregulation in Europe.  The development of an Euro-capital market, for instance, will deepen and broaden Europe's financial markets, lowering the cost of capital for European firms. The existence of a single currency will increase competition in European product markets, as consumers can easily compare prices across European countries.

 

European Domestic Risks of EMU

Against these potential advantages must be set a number of risks and costs. The most important of these stem from a country's loss of monetary independence and exchange rate flexibility.  Countries that join EMU will no longer be able to devalue their currency if their economies are hit by an outside shock.  Nor will they be able to set interest rates to suit their domestic purposes.  If countries within EMU are at different stages of their business cycles, pan-European interest rate policy may not suit their domestic situation. However, as Europe's economies converge, so their business cycles may become more synchronized.  In evaluating each of these risks, it is useful to make the comparison with the United States, a country that has had a single currency for far longer.

            The risk of recession, if an EMU-member country is hit with an economic downturn and demand drops, it will no longer be able to respond by loosening monetary policy.  Just as Texas could not loosen monetary policy in response to the Texas oil shock, nor California after the contraction of the defense industry, so individual countries within EMU will be stuck with the EMU-wide interest rate.

            Economists usually point to three ways that countries or regions can make up for this loss of monetary flexibility.  First, wage and prices must become more flexible.  If a region faces a downturn then real wages must fall relative to other parts of the currency union for that region to remain competitive.  Second, labor must be mobile.  People must be able to move from one industry to another, indeed from one region to another, in response to these kinds of shocks.  Third, stabilizing fiscal transfers - that is, budgetary spending which responds to economic shocks can to some extent offset these shocks.  So, countries or regions that give up monetary autonomy may well seek means for transferring fiscal resources.

            Compared with Europe, the United States has far greater labor flexibility.  The characteristics of continental Europe's labor markets--high unemployment benefits, high taxes, burdensome labor-market regulations--are well known to members of this subcommittee.  These problems currently limit labor market flexibility.  Under a single currency the costs of this inflexibility could become much more acute.

            Labor mobility is also far greater in the United States. America has a common language and a culture of mobility.  In Europe, by contrast, labor much less mobile.  Language, for one, proves a much greater barrier.  This immobility is a potential risk for the single currency, but it should not be exaggerated.  Not only do Europeans not move between countries, but they also are reluctant to move within countries.  Some 3% of American households move their region of residence in any year. In France or Germany only 1% of households move from one region to another in their country in any year, in southern Europe the share is even lower.  And European countries have had national currencies without significant internal labor mobility.

            One reason for this is fiscal transfers.  Within many individual European countries the level of fiscal transfers if very high. Within the European Union overall, it is very low.  The European Union’s budget is limited to 1.27% of the combined EU GDP, and it is spent largely on agricultural subsidies and regional aid that have nothing to do with the business cycle.  More concerning, the fiscal provisions in the Maastricht Treaty limit the extent to which national governments can use fiscal policy.  By comparison, the United States has far greater fiscal transfers.  The federal system of taxation ensures that when, say, New England faces a recession, it pays less in federal taxation and receives more transfers (such as unemployment benefit) from the federal government.

            Whether the members of EMU will be able to weather sudden recessionary shocks will depend on how far these characteristics change.  In particular, it depends on how flexible their labor markets become and how far fiscal policy is able to make up for the loss of control over monetary policy.

            The risk of volatility at the opposite extreme, is the risk that the Euro will not turn out to be the stable, strong currency its proponents hope for or that it will make macroeconomic policy within Europe more, rather than less, volatile.  This could occur in a number of ways.  Despite its statutory independence, the European Central Bank could succumb to political pressure from member countries that wanted looser monetary policy.  Although that is an unlikely outcome--it is in all EMU members' interests to build the new institution's credibility-it is not impossible.

            Policy-coordination will not always be simple.  The European Central Bank has responsibility for monetary policy, but broad decisions of the EU's exchange-rate regime are left with Ecofin, the European Union's committee of finance ministers. That it is rather like the division of responsibility between the Federal Reserve and the Treasury.  But in the ENIU area a further complication will come from the fact that fiscal policy will still mainly take place at the national level.  A new committee of finance ministers from ENIU countries only--so far dubbed "Euro-x"--will try to coordinate on policy issues pertinent to EMU.  That, in turn, may create friction and problems between those members of the European Union that are members of EMU and those that are not.

            The central bank itself may have teething problems.  The task of the Federal Reserve in setting monetary policy is far from simple.  Imagine how difficult it will be for a new central bank with no history of Euro-wide monetary aggregates or other indicators.  All central bankers rely heavily on historical trends when formulating monetary policy.  For the ECB such data will simply not exist.  In their absence, the technical challenge of setting an appropriate monetary policy is large, and the risk of getting it wrong commensurably high.

            This risk is increased by the fact that Europe's economies are entering EMU at very different stages in their business cycles. Ireland, Spain, Finland and Portugal, for instance, began their recent economic recoveries rather earlier than Germany or France. Short-term interest rates in these peripheral countries are now higher than Germany or France, and an interest rate appropriate to Germany may well cause Ireland's economy to overheat.

 

The implications of EMU for the international monetary system

The most obvious effect of EMU will be the creation of the Euro as a new currency in the international monetary system. Discussion of the implications of the Euro for the functioning of the international monetary system has intensified in recent months. Three main issues have emerged.

The first issue is whether the Euro will be a "strong "or a "weak" currency and reflects a misconception about the objective in creating EMU. EMU is designed to consolidate the framework of macroeconomic stability that has already been largely established in the European Union. The focus of EMU is clearly on internal stability and implies that the Euro will be neither weak nor strong but stable. The stability of the Euro will derive from good economic fundamentals and particularly a low inflation rate.                   

Although the Euro will be a stable currency, the Euro exchange rate is likely to vary over time and will reflect the interaction of many factors. These factors will include the cyclical conditions in the Euro-area economy relative to the other major economic areas, the Euro-area macroeconomic policy mix, more structural factors such as the underlying balance on the Euro- area current account and the perception of the world financial markets.

The second issue is the credibility of the Euro, especially in its early years. The EU economy has built up a considerable track record of price stability and EU inflation rates are now at their lowest levels for 35 years. The institutional framework of EMU, which is based above all else on the principle of monetary policy independence, will ensure that low inflation is preserved. The European Central Bank will enjoy greater independence than any other central bank - including the US Federal Reserve and even the Bundesbank. Moreover, the ECB has a statutory obligation to maintain price stability as its primary objective and the stance of monetary policy will reflect only this objective. As EMU will consolidate the commitment to low inflation, which has been established within the European Union, there is no reason to expect that the Euro will not be a credible currency from the outset.

The third issue is the role of the Euro as an international currency. EMU will mean the disappearance of existing national currencies in Europe so that trade between the member states participating in EMU will be denominated in Euro. It is also likely that the Euro will be used as a vehicle currency and as a reserve asset by those countries having strong trade and financial links to the EU. These would include the countries of central and Eastern Europe, Mediterranean countries and the CFA zone. Large and liquid financial markets with an ample supply of Euro assets will back the Euro. Given these developments, the Euro can be expected to be an important currency in the international monetary system. However, the evolution of the Euro into a major international currency like the US dollar will be determined by underlying economic fundamentals and market forces.

 

How EMU will affect Europe -- and its partners                       

When Europe is growing rapidly it is a more dynamic market for US exports -- and a stronger partner for the US around the world. Last year our total merchandise trade with the EU exceeded $270 billion -- an amount second only to Canada. More than half -- almost $400 billion --of US foreign direct investments are in Europe. Nor is this figure declining:  

American investment in Europe grew by roughly 11 percent, on average, between 1982 and 1995, somewhat faster than our investments in the rest of the world.  These figures are testament to the many trading and investment opportunities, which have resulted from recent moves toward closer European integration. It is worth noting that the closer convergence in economic policies, and changing market expectations, that have been associated with preparations for EMU have themselves brought significant economic benefits to many countries. In Italy, for example, long term interest rates have fallen by five and a half percentage points since the beginning of 1993, as the gap between Italian and German bond rates has fallen in line with increased expectations of Italy joining EMU. This increased market confidence in Italian assets has cut government borrowing costs substantially and done much to spur the Italian recovery.  And yet, for all the positive effects that increased integration has conferred, no one doubts that Europe still faces serious economic challenges -- challenges that will need to be overcome if EMU is to succeed.

First on the list is Europe's high rate of unemployment, which has continued to rise -- with only brief respites -- since the early 1980s. The average unemployment rate in the EU last year was more than 11 percent, roughly twice what it was in 1979. In some countries as many as I in 4 people in their early twenties is unemployed, while up to half of those out of work have been so for more than a year.  

The governments of Europe have repeatedly indicated that they plan to carry out the structural reforms needed to address both high unemployment and these looming fiscal pressures. Yet, as we have seen, it has often been difficult to build a political consensus to address these issues -- not least because for many, the reforms that are needed go right to the heart of the social democratic consensus in Europe which developed through the course of this century.

The advent of EMU will make it more, rather than less vital for governments to proceed with these structural reforms if Europe is to enjoy robust growth. Given a shock to domestic demand, individual members of EMU will no longer have any freedom to respond by devaluing or revaluing their currency, or cutting or raising interest rates. Nor -- given the combined constraints of the fiscal stability pact and existing debt and deficit levels -- will they able to use fiscal stimuli to support growth.

If coping with the new currency were to distract policy makers from the need to pursue fundamental reforms, the reduced economic autonomy of the participants could thus come at the price of forgone growth. This makes it all the more encouraging to hear voices across the European political spectrum acknowledge that EMU requires structural reforms to succeed, and that EMU should push policies in that direction. As we have seen in the recent flood of cross-country mergers and acquisitions, the European private sector is already responding to the demands of the new situation. The challenge will be for governments to build on the growing consensus in favor of change -- and channel it into genuine structural reform.

 

The implications of EMU for the international monetary system

Just as it would be unfortunate if EMU distracted European policy makers from their domestic challenges, it must not distract them from the important international challenges Europe faces. Particularly critical in this context is the expansion of the EU to incorporate several countries of the former Soviet bloc.

More broadly, it will be important in the years after EMU for the European Union to dispel any remaining fears about the creation of a "Fortress Europe" by continuing to open up its markets and strengthen its ties with the global economy. EMU will raise issues for the future evolution of the G-7, and the nature of Europe's participation in international organizations such as the International Monetary Fund. We look forward to engaging with the EU on these matters next year after the selection of the first members.                          

Efforts to resolve these issues must have one vital goal: that Europe emerges out of EMU with the capacity to play an active, constructive role on the world stage on political, monetary and other matters. The corollary is that European policy makers will have to avoid being overly preoccupied with building and refining the architecture of monetary union.

 

The Euro's Future Role in the Global Financial System

The creation of a new European currency on January 1, 1999 would mark the biggest change in the international monetary system the breakdown of the Bretton-Woods system in the early 1970s. It would truly be an event without precedent, either in European history or the history of the world. Clearly, the United States will have a major interest in the impact that such an event might have on the international financial landscape.

There have been two kinds of issues raised in this context: first, the impact of EMU on the international role of the dollar; and second, the potential effect on short-term trade and exchange rate developments.

The more the single currency helps Europe develop a robust and healthy economy that is open to world markets, the more welcome the project will be.

 

The Implications of EMU for the United States      

 

By ensuring macroeconomic stability and responding to the challenges of globalization, EMU will allow the EU economy to operate more efficiently. The benefits will certainly not be confined to the European Union but will spill over to other parts of the international economy - and notably to the United States. 

The US has the same interest with regard to the creation of a single currency that we would have with respect to any major development in Europe. America will be well served when the region is vibrant economically, and is working to open its markets and strengthen its ties with the global economy. Europe will prosper from an economic and monetary union that supports these ends -- and if Europe prospers, this will help prosperity in the United States.

Firstly, EMU will create a more dynamic and prosperous EU economy. This will provide increased opportunities for trade with the United States, which is already the EU's largest trading partner.

Secondly, EMU will ensure that the European Union is a zone of low inflation and sound public finances. A stable EU economy will contribute to a smoother-functioning international monetary system and, most importantly, lower long-term interest rates across the world economy. The importance of this contribution is underlined by the recent report from the G-10 Deputies in which the link between budgetary imbalances, high long-term interest rates and low savings rates is emphasized.                         

Thirdly, US businesses located in the EU market will find it easier to operate in a single currency environment. Transaction costs will be lower, the need for exchange rate hedging will be reduced and marketing strategies can be consolidated.

Finally, EMU offers major opportunities to the US financial sector in particular. The integration of the many member state financial markets will result in the creation of large and highly liquid Euro markets. For example, all new issues of government debt in the Euro area will be denominated in Euro from I January 1999 so that the volume of new government debt issued in Euro will be at least equal to that currently issued in dollars by the US Treasury. Apart from the greater size of financial markets, the Euro will also create a demand for a wider range of financial instruments.  In this context, the experience acquired by US financial institutions in their highly developed domestic markets will be an important advantage.               

 

            The possible bipolar monetary system that might emerge between Europe and the United States will not be all smooth sailing.  One only needs look at the potential crisis that looms between the US and the EU over the banana trade.  Now in its seventh year, a dispute over the yellow-skinned fruit has triggered multiple international lawsuits and could turn into a tit-for-tat trade war. U.S. officials are threatening to announce massive punitive tariffs this month on $500 million worth of European goods ranging from cashmere sweaters and chandeliers to Louis Vuitton handbags. In return, the Europeans accuse Washington of displaying "unilateralism at its worst."

Neither side produces bananas in any large quantity. And few U.S. or European jobs are directly at stake. The facts of the dispute are fairly clear. U.S. officials object to an EU practice of giving preference to its former colonies in Africa and the Caribbean for its banana imports. The EU's rules hurt American-based producers Chiquita Brands International and Dole Food Co., whose bananas come from several Latin American nations.

Peeling away the rhetoric, the real fight is about the power of the WTO. The United States fears setting a precedent that would weaken the trade organization. The banana dispute is every bit as ludicrous as it sounds: it threatens the multilateral trading system at a time when trade is crucial for the world to avoid a deep recession.  The spat has poisoned relations between America and Europe at a time when their close co-operation is more important than ever.  Most of the world economy is in a funk; only America and, to a lesser extent, Europe are keeping it afloat. 

This is already stoking up protectionism in America.  America’s trade deficit has rocketed to a record high, provoking squeals from companies and politicians alike.  There is even talk among officials of reviving the unilateral battering ram known as “Super 301”, the cause of much trade friction in past.  Since protectionism is up on the up even in an American boom, the rest of world could be in for a mauling when that economy eventually slows. 

Let me highlight a possible situation that might occur in the near future.

There are people questioning what will happen if the United States economy starts to cool off a little bit in the next 18 months, one of the things that might otherwise happen is for interest rates to continue to drop.  But, if there is now competition with the Euro, America might want to make it’s interest rates more attractive and make it in the investors best interest to hold dollars.  When these two conditions square off, who wins?  In this instant the market usually wins, and what the markets could do in that situation is to push interest rates up.  America would then end up paying the price for its own profligacy.  The US has been running trade deficits this year on the order of $300 billion.  America has accumulated a net foreign debt that’s approaching $2 trillion.  That’s the dirty secret of the American economic miracle of the last 20 years. 

Lately the US has had rapid growth, been at full employment, had inflation hardly seen, but it’s been largely financed by foreigners.  America has been running huge trade deficits, as foreigner put money into its economy.  The fact that the US’s private savings rate has almost disappeared has been offset by foreign savings coming in.  This has enabled America to have this consumption boom, with rapid economic growth, funded by others.  Don’t get me wrong.  Foreigners have benefited as well.  However, if confidence were lost, if the world suddenly decided that the Euro looked relatively attractive to the dollar, i.e. they wanted to put their money in Europe, America would have to start paying the piper, and in an underlying sense, it would be payment for the fact that America has lived the pretty high life at the expensive of others’ for a considerable period of time.  If the world slowdown is not lead to a trade crisis, America and Europe need to work together.

 

Conclusion

 

The steady progress in technical preparations for EMU has also fostered credibility. These preparations have been complicated and often politically sensitive. For example, the effort required bringing all member-state legislation on government enhancing into conformity with the principles of monetary policy independence in EMU. Operators have also adopted the legal framework for the use of the Euro in order to facilitate operations. The Stability and Growth Pact should also be mentioned in this context. The Pact represents an EU-wide agreement on measures to ensure budgetary discipline in EMU and the long negotiations on the Pact echoed many elements of the recent balanced-budget debate in the United States. Preparations for the operation of a single monetary policy with harmonized monetary instruments and an integrated system of payments and settlements are well advanced. Preparations are also underway within public and private sector institutions. Public administrations must be ready to undertake budgetary transactions in Euro while financial institutions and corporate enterprises are preparing themselves to deal with the emergence of Euro financial markets.

The EMU is a further step in the process of European integration, which has been going on for the past 40 years. It is not a "leap in the dark". Its foundations are firm. These foundations are the unswerving political will of the member states, together with the macroeconomic stability and convergence that they have already achieved. EMU will strengthen the European Union as it embarks on its next great challenge - enlargement to the East. The EMU that is being created will be reliable and stable. It will be good for the EU economy, for the US economy and hence for the economies of the rest of the world.

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