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.
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.
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