Download The Birth of the Euro and Its Effects

The Birth of the Euro and Its Effects
The Birth of the Euro
and Its Effects
ROBERT SOLOMON
Guest Scholar
The Brookings Institution
T
he euro was born at the beginning of this year as the currency of the
newly formed European Economic and Monetary Union (EMU). As has
been widely observed, this is a historic event. Not since the Roman
Empire has a good part of Europe had the same currency.
EMU was conceived in 1988–89 by a committee consisting mainly of central bankers chaired by Jacque Delors, then president of the European Commission. The initiative, however, came from the political authorities, especially those
in France and Germany. Eleven of the fifteen European Union (EU) countries
are EMU members—all but Denmark, Greece, Sweden, and the United Kingdom.
The euro is managed by the new European System of Central Banks, also
known as the Eurosystem. In January the euro began to be used in place of the
national currencies in banking and other financial transactions and in the denomination of securities. But hand-to-hand currencies will not be replaced by
euro notes and coins until 2002. Prices in some retail shopes are being quoted in
both national currencies and euros, and credit card purchases can be made in
euros.
Antecedents of EMU
EMU represents the latest in a long series of measures in the process of economic
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and monetary integration in western Europe, going back to the early postwar era.
Trade among those countries was liberalized under the Marshall Plan, while restrictions were retained on imports from the United States. Six continental European countries established the Coal and Steel Community (the Schuman Plan) in
1952. The European Economic Community came into existence as a customs
union or “common market” in 1958 among the same six nations. In 1970 they
put forth a proposal to form a monetary union, but these plans were put aside
because of the economic and monetary turbulence of the 1970s.
In 1979, under the influence of Helmut Schmidt, then chancellor of Germany, and Valéry Giscard-d’Estaing, then president of France, eight original member countries set up the European Monetary System (EMS) as a “zone of monetary stability” with linked exchange rates. The EMS became, in effect, a German
mark zone, since its members pegged their exchange rates to the mark and therefore found it necessary to base their monetary policy on that of the Bundesbank.
Both inflation and interest rates tended to converge among EMS countries.
In 1986, the so-called Single European Act aimed to free the movement of
goods, services, capital, and people among EU countries by 1992, in order to
form a Single Market, as it was called.
Formation of EMU
Germany’s dominance in the EMS in part motivated French officials to propose
that a monetary union be formed. Another reason for the proposal was that some
Europeans feared that the Single Market might be endangered if exchange rates
were not locked together. Thus the Delors Committee was established in 1988.
The report of the Delors Committee led in 1991 to the Maastricht Treaty
(Treaty on European Union), which may be regarded as the constitution of EMU.
Even before that, “convergence criteria” were established pertaining to the size of
budget deficits and national debt, inflation, interest rates, and exchange rates;
these criteria were designed to provide the basis for choosing which countries
qualified for EMU membership. As it turned out, only Greece failed to qualify.
Denmark, Sweden, and the United Kingdom chose not to join at the outset.
Countries of the EU made strenuous efforts to meet the budget deficit
criterion, including some “creative accounting” such as counting the proceeds of
privatization and central bank profits from the sale of gold as budget receipts.
Actual budget constraints exacerbated the economic slowdown in the EU in 1996–
97. It would have made more sense to base the criterion on structural—that is,
cyclically adjusted rather than actual—budget deficits.
It is understandable that some restraint on the budgetary policies of member countries would be needed in the monetary union. In 1996 a Stability and
Growth Pact was agreed upon. It provided a general rule that deficits should not
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exceed 3 percent of GDP—but also allowed for political discretion. In fact, if a
country’s GDP were to fall by 2 percent or more in any year, it would not be
penalized for a deficit greater than 3 percent of its GDP. It is somewhat ironic that
this pact acknowledged the existence of the business cycle but the convergence
criteria did not. As is discussed below, flexibility of fiscal policy is necessary on the
part of individual member countries of EMU.
Political motivations propelled each of the moves toward economic and
monetary integration. Immediately after World War II, under the influence of
Jean Monnet and Robert Schuman, France adopted the policy of embracing Germany and keeping it oriented toward the West. Beginning with Konrad Adenauer,
Germany’s leaders supported a reciprocal policy. The history of warfare between
the two nations dating back to the nineteenth century inspired this policy approach, which successive governments have pursued up to today.
Thus the long series of economic and monetary measures in western Europe has had a basic political rationale. So far, however, political integration has
not gone beyond establishing the various bodies of the European Union, among
them the Commission, the European Parliament, and the European Court of
Justice. Although a “pillar” of the Maastricht Treaty established “common security and foreign policy,” that has not yet proceeded very far.
Features of EMU
The euro area—the eleven countries comprising EMU—has a population of about
three hundred million, nearly 10 percent more than in the United States. Its
economic size, measured by GDP, is about three-fourths that of the United Sates
and almost twice that of Japan.
The creation of EMU has altered the composition of the world economy in
the sense that it has become more concentrated. The euro area, the United States,
and Japan together are responsible for about 43 percent of world GDP and 36
percent of world exports.
Before EMU, the member countries of the euro zone were quite open to
the rest of the world as measured by their exports and imports. But much of that
trade is within EMU and now internal trade. External exports plus imports of
goods amount to just over 25 percent of GDP, compared with almost 20 percent
in the case of the United States. Thus the euro-area economy is only slightly more
open than the American economy.
Three differences between the euro and the United States are worth noting.
First, government expenditures are much larger as a proportion of GDP—almost
50 percent—in Europe than in the United States, where it is about one-third of
GDP.
Second, unemployment, at about 10.5 percent of the labor force, com-
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pared with just over 4 percent in the United States, is a serious economic and
political problem in Europe. Many believe most of that unemployment to be
structural rather than cyclical—related to labor-market policies and high taxes
and other charges on the employment of labor.
The third difference is that labor is much more mobile among states and
regions of the United States than it is among European countries with their differences in language and culture. According to the concept of optimal currency
areas, labor must be free to move from areas of high to low unemployment in
order to give up the ability to change the exchange rate. On the other hand, some
argue that the very existence of EMU will lead to greater labor mobility. In any
event, there is another way to deal with differences in the level of economic activity and therefore employment among countries of a monetary union—namely,
fiscal policy flexibility in every country.
The Central Banking System
The Maastricht Treaty provided that the Eurosystem’s “primary objective” is price
stability. But the treaty also stated—and this is not widely recognized—that the
central bank shall support the general policies of the community, including growth
and employment, without prejudice to the primary objective.
The Eurosystem consists of the European Central Bank (ECB) in Frankfurt and the central banks of the eleven member countries. Wim Duisenberg,
former president of the Netherlands Bank, presides over the ECB. The ECB has
a six-member Executive Board. That Board plus
The structure of the eleven national central bank governors constithe Eurosystem re- tute the Governing Council, the principal policymaking body of the Eurosystem. It is evident that
sembles that of the the structure of the Eurosystem resembles that of
Federal Reserve the Federal Reserve System in the United States.
System in the U.S. The ECB Executive Board is the counterpart of
the seven-member Board of Governors in Washington; the eleven national central banks are like the twelve regional Federal Reserve Banks in the United States, and in both cases actual market transaction are
conducted at these banks rather than at the central board; the Governing Council
is similar to the Federal Open Market Committee, which is responsible for setting monetary policy. One difference is that in the Eurosystem the national central bank presidents outnumber the Executive Board in voting power on the Governing Council, whereas in the Federal Reserve System, the Board of Governors
has a voting majority, since not all twelve Federal Reserve Bank presidents have a
vote at all times. Whether that difference is significant remains to be seen.
The Eurosystem has determined that its monetary policy will be guided by
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two “pillars”: (1) an inflation target in the form of “a broadly based assessment of
the outlook for future price developments and the risks to price stability in the
euro area as a whole,” based on a Harmonized Index of Consumer Prices (HICP)
and (2) a “reference value”—not a specific monetary target—for the growth of a
broad monetary aggregate. It has established three interest rates: a basic “refinancing rate” akin to the Federal funds rate in the United States, a marginal lending
rate comparable to a discount rate, and a deposit rate paid to banks on idle funds.
The basic rate was initially set at 3 percent in early January.
On April 8 the Governing Council decided to lower the basic rate from 3
to 2.5 percent and also to reduce the other two rates, presumably because of the
weakening in economic activity in the euro area. Germany’s real GDP actually
declined in the fourth quarter of 1998, and the short-term outlook was not favorable. For the euro area as a whole, the IMF projected GDP growth to slow from
2.9 percent in 1998 to 2.0 percent in 1999. This policy action was significant not
only because it revealed a welcome degree of flexibility in the Eurosystem, but
also because it demonstrated that price stability is not the only policy objective of
the central bank.
Meanwhile the foreign exchange value of the euro, which was set at $1.18
on January 4, depreciated almost steadily thereafter to be just below $1.06 in
early May. This decline in the dollar value of the euro was widely attributed to the
remarkably strong performance of the American economy and the lower interest
rates in the euro zone than in the United States.
Given the fact that the U.S. balance of payments is in large and growing
current-account deficit while the euro area has a surplus in its currect account,
this exchage rate movement was somewhat surprising. It also ran against the
predicitons of some well-known observers that the euro would attract large amounts
of funds out of official dollar reserves and private dollar holdings around the
world.
Domestic Economic Effects of EMU
While the national economies of the euro area have become integrated and have
already converged in many ways, the move to a single currency is likely to have
further effects in those directions. The elimination of the transaction costs of buying and selling foreign exchange and of the time and effort involved will encourage
trade among the euro-area countries. The elimination of uncertainty regarding future exchange rates will have a similar effect in encouraging trade and also direct
investment among the countries. Beyond that, firms that use the same currency are
more likely to trade with one another. Finally, the elimination of exchange rates
protects the single market. A large depreciation of an EU currency might have
tempted other EU countries to impose restrictions on imports from that country.
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Financial markets are also likely to develop. A difference between Europe
and the United States is that a much larger share of finance is done through banks
in Europe, while securities markets are more developed in the United States. With
a larger area using the same currency and with uniform interest rates, capital
markets are likely to become more important in the euro zone. That could also
have international effects, as is discussed below.
Dealing with Asymmetric Shocks
Suppose that one country in the euro area goes into recession while the rest of the
area does not. What can this country do? It cannot alter its monetary policy,
which is determined by the Eurosystem. It does not have an exchange rate to
change. In contrast to U.S. states, where tax payments to Washington drop and
unemployment compensation receipts rise when a recession occur, it will not be a
net recipient of transfers from the capital via the so-called built-in stabilizers. And
few of the unemployed will migrate to other countries.
The country’s own built-in stabilizers will provide some offset, as tax payments decrease and unemployment benefits increase. But they are unlikely to
offset the contractionary forces completely. The only other instrument available
is a deliberate change in fiscal policy—a cut in tax rates or an increase in government expenditures, or both. If the country’s budget has been near balance or in
surplus or if its GDP declined by 2 percent or more in one year, that would be
possible without running into the constraints of the Stability and Growth Pact.
If the asymmetrical shock is in the other direction—inflation in one country while price movements in the other, members of the area are consistent with
the aims of the Eurosystem—fiscal policy would again be the only instrument
available. But the Stability and Growth Pact would not be a hindrance. It does
not restrain countries from adopting policies that move their budgets toward
surpluses.
It follows that it is desirable for member countries of EMU to keep their
budgets near balance in good times. That would provide the leeway to use flexible
fiscal policy to offset differential movements in their economies.
International Effects of EMU
The euro’s exchange rate will float in relation to the dollar and other currencies,
except for those of countries that decide to peg to the euro. The proposal of
Germany’s former finance minister, Oskar Lafontaine, that a system of target
zones for exchange rates be adopted, was rejected by the ECB among others.
The world-wide effects on economic activity of the euro area are impossible to predict. That will depend on the macroeconomic performance of the
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area, which in turn will be affected by both the policies of the Eurosystem and the
fiscal policies pursued by the individual countries. The hazards involved in trying
to forecast future economic activity are well illustrated by the surprisingly strong
performance of the U.S. economy in 1998 and early 1999.
The principal questions that have been raised regarding the international
effects of EMU have to do with the international monetary system. Will the euro
become a major reserve currency displacing the dollar to a greater or lesser degree?
The dollar also plays a large role as a private international asset and liability, serving internationally in the three monetary functions: a unit of account, a means of
payment, and a store of value. Will the euro take over some of these functions,
and, if so, how rapidly?
The dollar has been the world’s principal reserve currency for many years.
At the end of 1997, 57 percent of all foreign-exchange reserves were in dollars.
Countries close to the euro area and aspiring to become members of the European Union, such as some in eastern Europe, are likely to peg their exchange rates
to the euro and could well convert much of their reserves into euros. But central
banks in general will not throw dollars on the market in exchange for euros. That
would lower the value of their remaining dollar reserves. Thus, to the extent that
substitution takes place, it will be a gradual process. Further, many countries in
Latin America and Asia have closer economic and financial relations with the
United States than with Europe; they are likely to keep their reserves in dollars.
As to the growth of reserves, it should be remembered that there must be a
supply of as well as a demand for a currency if it is to account for a growing share
of countries’ reserves. In other words, a reserve center of increasing importance
must incur an overall balance-of-payments deficit: either a current-account deficit or an outflow of capital larger than its current-account surplus. The United
States has amply demonstrated this principle over the past half-century.
As noted earlier, the euro area has a current-account surplus of about100
billion U.S. dollars annually. But its net lending to the rest of the world is much
less than that. If the euro component of countries’ reserves is to increase, there
will have to be a much larger outflow of capital from the euro area.
A related condition for a country or area to become a major reserve center
is that it have financial instruments in which reserve holders are willing to invest
and financial markets in which they are willing to borrow or sell securities.
A similar set of conditions hold for euro assets to become an important
currency in private portfolios around the world.
Thus the development of capital markets in the euro area is a necessary
condition for the euro to evolve into a major currency in official and private
portfolios. How important it will become is hard to predict. But the process is
likely to be gradual.
Should the United States be concerned about that possibility? The dollar’s
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role as a reserve and privately used international currency does not bring enormous advantages. After all, interest is paid on foreign holding of dollars. It is not,
as General de Gaulle characterized it back in the 1960s, an “exorbitant privilege.”
The notion that American influence in the world depends on the dollar’s
role seems greatly exaggerated. The sole superpower with the strongest economy
in the world will have influence regardless of the international role of its currency.
Ironically, just as the euro comes on the scene as a potential competitor of
the dollar, there is talk in a number of countries of “dollarization,” that is, adopting the dollar as their domestic currency in addition to its international role.
Whether or not that happens, there is no serious reason why the United
States should be concerned about the birth and development of the euro. Its
economic and political rationale should meet with strong American approval. WA
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