Quarter 4, 1998
by Jane Little

The new millennium came early in Europe. (Doubters, mostly joking, say the apocalypse.) On January 1, 1999, eleven European nations started the final approach to European Monetary Union (EMU). On that date, for better or worse, they locked the value of their currencies irrevocably together and gave control over what is now, per force, a single European monetary policy to a single supranational authority. For the foreseeable future, Europe's economic health and status depend on the success or (unthinkable!) failure of this extraordinary experiment. In the United States, the outcome matters because Europe absorbs one-quarter of this country's exports. And New England, for obvious historical and geographic reasons, is even more dependent on Europe than is the nation; one-third of the region's exports go to Europe.

More fundamentally, however, the introduction of a single European currency for use throughout the huge European market represents the biggest change in the international monetary system since the end of the dollar standard in 1971. This effort by European policy makers to achieve an extra degree of economic clout for the bloc as a whole is likely to force major changes in the governance and psyche of Europe. Moreover, if this model is emulated elsewhere, EMU could spawn a handful of large, potentially competitive single-currency blocs. This possibility makes developing deeper multilateral trade and investment ties a continuing imperative.

WHY EMU?

Emerging from the devastation of World War II, European leaders dreamed of building an economic and political union that would make a repetition of the previous fifty years forever impossible. According to Jean Monnet and Robert Schuman's original vision, the primary goal of economic integration was to bind a peaceful, prosperous Germany inextricably to the West. The end of the Cold War, Germany's reunification in 1990, and its growing ties to Eastern Europe strengthened this imperative, but also broadened it to include anchoring the transitional economies of Eastern Europe to the market economies of the West. Moreover, and particularly since the collapse of the Soviet threat, another motif — achieving the economic and political cohesion to counterbalance the U.S. voice in world affairs — is frequently audible. As Jacques Santer, president of the EU's executive commission put it last May, "Thanks to the euro, in one single blow, Europe is imposing itself on the world financial and monetary map."

Pursuing these largely political goals, Europeans have relied on the logic of the market. Europe's federalists have long perceived that growing commercial links, supported by business, would create shared interests and, thus, forge closer political ties among sometimes suspicious neighbors. As an early step, the Treaty of Rome (1957) created the European Economic Community, a common market for goods that was expected to offer the efficiency of free trade on a scale long available in the United States. Growing trade and investment ties then produced demands for more stable currencies. But, since separate currencies can never be forever fixed, a whole series of plans for creating exchange rate stability within Europe achieved just limited success; periodic currency crises continued into the early 1990s.

By then, the Europeans had removed restrictions on the internal flow of services, capital, and labor, as well as goods, but integration remained incomplete — as is true in the United States and Canada, despite NAFTA. Here, the national border still looms as a far bigger barrier to trade than do state/provincial boundaries, in part because we keep separate currencies. Thus, in late 1991, the EU governments agreed to replace their national monies with a single currency; they codified this decision in the Treaty on European Union, signed in Maastricht in early 1992.

By so doing, the Europeans believe they will reap economic, as well as political, benefits. First, they have eliminated the need to hedge against currency fluctuations and will avoid other accounting costs, with savings totaling at least $65 billion annually. More important, because pricing in euros makes comparison shopping easier, the single currency should spur European competition and, thus, efficiency. The euro will also allow national bond and stock markets to merge into integrated European capital markets. Large, liquid markets are less volatile and, thus, less risky and more attractive to prospective participants. Combined, Europe's government bond markets are about as large as the U.S. government securities market. But the corporate bond and equity markets total one-sixth and one-third the size of the U.S. equivalents. The London and Frankfurt exchanges have already joined; plans to include another six markets are under way.

Adopting a single currency also forces the Europeans to adhere to a single monetary policy geared to the needs of the union, not the individual members. Devaluing against other EMU countries - to accommodate different national rates of inflation, say — also becomes impossible. Yielding such important policy tools to a multilateral authority represents an extraordinary cession of power. But, compared with the United States, the individual European economies are small and exposed to foreign trade; thus, European nations have been much more vulnerable than this country to the impact of exchange rate swings on inflation and growth. For this reason, even the Germans have usually had to conduct monetary policy with one eye on their exchange rate in a way that the United States has not. Creating a single currency and a large internal market (where foreign trade is no more important than it is here) will allow the Europeans to treat the euro exchange rate with the same "benign neglect" the United States accords the dollar. Europe's leaders expect that ceding power at the national level will gain them extra freedom in setting policy at the European level. In addition, since most EMU members have had to devote monetary policy to meeting exchange rate targets during the approach to EMU, they have had limited policy freedom for some years now.

PREREQUISITES FOR EMU

Using a single monetary policy to harness strikingly dissimilar economies veering in divergent directions could lead to quick disaster. Accordingly, the Treaty of Maastricht set out a list of criteria to measure whether nations with such different tastes for inflation as Italy and Germany were really ready to yoke themselves together. These measures included exchange rate, inflation, interest rate, and fiscal targets. Despite much initial skepticism that the Mediterranean candidates could meet these goals, in May 1998, the Council of the European Union announced that all eleven countries seeking to start EMU's final stage in the first wave had qualified.

For interest rates and inflation, convergence was surprisingly easy. As investors saw that EMU was within reach, even for the outliers, expected inflation fell; interest rates and actual inflation followed. Declining interest rates also cut the cost of accumulated debt, helping countries meet their fiscal goals. Indeed, the Mediterranean candidates made a dash to qualify in the first round to take advantage of these favorable dynamics and the political will to "make EMU." Still, only four members actually met the debt-to-GDP target; even Germany had to rely on the Treaty's flexibility on that point.

Looking ahead, fiscal prudence remains the expected order. To keep fiscal irresponsibility in one nation from undermining monetary stability for all, the June 1997 Stability and Growth Pact provides for ongoing EU surveillance of members' budget policies and for payment of substantial fines for "excessive" deficits. Unless members bring their budgets close to balance in fat years, they will have little room to use fiscal stimulus when times are lean.

1999 – THE NEW ERA

The euro now serves, alongside national monies, as a unit of account throughout Eurolande — as the French prefer — even in the Vatican and St. Pierre and Miquelon, the French specks off Canada. Already, banks, large firms, and governments are pricing in euros; all newly issued government debt must be denominated in euros; but, for now, retailers may choose which currency to use. Euro notes and coins will not circulate until January 2002. Six months later, at most, national notes and coins will cease to be legal tender. Logistical considerations — the need to distribute huge volumes of coins and to adjust all parking meters and vending machines, for instance — require the overlap. Europe now uses 76 billion coins and 3.2 million vending machines.

In synch with the above changes, the Governing Council of the European System of Central Banks (the ESCB) now sets monetary policy for the EMU-11. This Council comprises the six-member Executive Board of the European Central Bank (ECB) and the heads of the central banks of the eleven participating countries. (It thus resembles the U.S. Federal Open Market Committee, composed of the Board of Governors and the presidents of the twelve Reserve Banks on a rotating basis.) The ESCB is entirely independent; by treaty, the ECB and the central banks are forbidden to take instruction from any national government or European institution like the European Parliament. Unlike the Fed, which is ultimately a creature of Congress, no political body can abolish the ECB. This lack of accountability is a major problem, critics say, since, in democracies, central banks must be seen as legitimate as well as credible.

By treaty again, the ESCB's primary objective is ensuring price stability (inflation below 2 percent a year) — a natural choice after decades when inflation has been the main macro danger in many countries. Now, however, with EU prices rising just 1 percent a year on average, slow GDP growth may look a bigger threat than inflation to many, including the center-left governments newly elected in most EMU countries. These governments campaigned on reducing Europe's stubbornly high unemployment rate (now 10+ percent). But, with European growth widely expected to slow to 2 percent in 1999, and national fiscal policy constrained by the stability pact, cutting unemployment will be hard. Thus, some European governments are seeking ways to balance (or influence) the ECB. While any institutional change, such as the launch of EMU, is likely to cause some jockeying for position, slow growth will aggravate the inevitable conflicts; and a major downturn, when it comes, will almost surely spark efforts to improve ECB accountability, to develop countercyclical fiscal policy at the European level, or both. If these efforts don't succeed, political instability could result.

Conducting monetary policy at the start of this new era will be a challenge. EMU is already spurring major changes in the financial system, like cross-border and cross-industry mergers and the spread of new techniques, like securitization; thus, just as the introduction of NOW and sweep accounts blurred money supply data as a policy guide in this country, European money supply numbers may also turn more volatile and harder to interpret. As a result, the ESCB is using an eclectic approach, with an explicit inflation target (as in Britain), as well as a money supply indicator (preferred by Germany). Once the Governing Council sets policy, the national central banks carry it out- primarily through the purchase and sale of government securities, as in the United States.

Implementing ESCB policy will require skillful coordination of the national central banks, although the Europeans clearly know the Fed's early history. At first, for political reasons, the individual Reserve Banks had considerable independence; it took from 1913 to 1933 to recognize the impracticality of that arrangement and centralize control. By contrast, the ESCB constitution clearly states that national central banks will implement policy at the direction of the ECB. Still, the potential for conflict exists. For example, ESCB open market operations involve purchase and sale of national debt that now resembles U.S. state bonds. (On January 1, 1999, this debt lost its sovereign status since European governments can no longer print money to pay their liabilities.) Thus, ESCB operations could influence relative borrowing costs to the benefit/detriment of individual governments. Similarly, responsibility for bank supervision rests at the national level while the ECB is the only possible lender of last resort. Will coordination and cooperation between these two different levels of government be adequate in the event of a future banking crisis?

HERE TODAY, GONE TOMORROW?

Many, possibly most, U.S. economists are skeptical about EMU's long-term viability. They fear that shocks that hit some regions harder than others (like the U.S. oil-patch problems of the mid-1980s or the New England banking crisis of the late 1980s) will cause major distress, now that Europe has a single monetary policy and national fiscal policies are constrained. And, clearly, that fear is not entirely misplaced. The Asian financial crisis has hit the commodity producers of northern Europe harder than their southern neighbors, for example, while the Russian default has had a more noticeable impact on Germany and Italy. Ireland and Spain are currently overheating, while in core Europe demand is weakening unexpectedly fast. A one-size-fits-all monetary policy cannot address Irish and German needs simultaneously.

In the United States, flexible labor markets help buffer regional crises, but European labor practices (national wage bargains, hiring and firing rules, and the like) are notoriously inflexible. Similarly, when workers move easily between regions, regional downturns tend not to last. But European labor is a lot less mobile than its U.S. counterpart — witness unemployment rates in the Italian Mezzogiorno and the East German states that remain double or triple the national average for years, even decades. While only a small fraction of Americans change their region of residence in a given year, according to OECD data, that is three to five times the internal mobility shown by the British and the Italians. Cross-border mobility is even more limited, and will probably remain so, given language and cultural barriers.

In addition, in the United States, progressive income taxes and various safety net programs, like the federal share of unemployment insurance and Medicaid, help to offset regional shocks. Pre-EMU, economists Bayoumi and Masson, and Obstfeld and Peri found that national fiscal policy played as great a role in buffering internal regional shocks in individual European countries as in the U.S.; thus, they concluded that European governments actually have significant scope for countercyclical fiscal policy. However, now that they are bound by the Stability and Growth Pact, EMU members may not be able to offset regional shocks within their borders as readily as before. But as yet, the EC budget is too small for automatic stabilizers to operate on a meaningful scale across Europe. In 1996, the EC budget amounted to 1.2 percent of members' GDP while U.S. federal spending equaled 40 percent. Thus, European governments will likely face growing pressure to fund Europe's safety net and other programs on a multilateral basis.

Business cycles in EMU countries may also become more synchronous over time, thanks to the bonds of a single monetary policy and growing trade and investment links. According to Jacob Frankel and Andrew Rose, currency areas tend to become more "optimum" or appropriate after the fact than they were before. In addition, the development of European capital markets may lead Europeans to invest in far-flung parts of the community. As Barry Eichengreen has suggested, the income from geographically diverse investments provides another way to insure against regional shocks.

All told, EMU tensions may be every bit as severe as doubters fear. But the Europeans have chosen their path, and there's no turning back - at least, there's no provision for turning back. Thus, the inevitable strains are likely to spur needed adaptations rather than retreat or revolution.

EMU AND US

With Europe's economic importance and the likely size of euro financial markets, the euro will probably assume and expand the mark's previous role as an international business and reserve currency. The dollar's status as the world's primary transactions currency could even be "threatened." Would such displacement matter? According to most economists, not much. At bottom, they argue, a somewhat reduced global role for the dollar would bring little meaningful change beyond slightly increased borrowing costs for the U.S. government. Similarly, if foreigners are somewhat less willing to hold dollars (and, thus, finance the huge U.S. trade deficit that allows us to consume and invest more than we produce), the euro may reduce what the French used to call this country's "exorbitant advantage."

Given the ESCB's heritage, mandate, and independence, the euro is likely to be a strong currency over the long term, while short-term currency moves will reflect the immediate outlook for the U.S. and EU economies — as they do now. Since exchange rates provide a useful adjustment mechanism, these currency swings will often be welcome. But, as the Asian currency crisis showed all too clearly, forex markets sometimes exhibit excessive volatility that destabilizes domestic prices or hurts firms producing traded goods. As Europe's markets for goods and capital grow as large or larger than ours, the U.S. may experience a new sensitivity to unwanted exchange rate swings, while the Europeans may feel more protected.

If Europe is indeed able to gain a degree of economic independence by adopting a single currency and creating a continental market for goods and capital, other countries may be tempted to follow. Some officials in the Mercosur countries of Latin America are already contemplating a single currency (or possibly dollarizing instead). Might the Southeast Asians do the same, as Joseph Yam, Chief Executive of the Hong Kong Monetary Authority has already suggested? Would such blocs turn out to be rivalrous? Or will currency blocs generally force their members to develop additional supranational institutions — fiscal and supervisory authorities, for instance — as forecast for EMU? If so, currency blocs may pave the way to supranational policy making on a broader scale.

EURO/DOLLAR PORTFOLIO SHIFTS.
HOW MUCH? HOW SOON?
Foreign governments now hold about 70 percent of their foreign exchange reserves in U.S. dollars. And European governments now need far fewer reserves in total than they did when they had bilateral EC exchange rates to manage. But since official reserves make up less than a third of international portfolios, the private sector's currency preferences dominate.

In March 1998, 45 percent of international debt securities were denominated in dollars, 34 percent in EU currencies. Given investor inertia, portfolio shifts will likely be relatively smooth. Still, 50 percent of all international bonds issued in January 1999 were euros, 40 percent in dollars. Thus, a gradual transition is not an entirely sure bet.