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History Table of Contents
1999 Winter Conference
 
Winter Conference 1999
The New Europe and the Atlantic Relationship
Growth, change and opportunities...a comprehensive evaluation

Euro Currency

Sylvia Ostry

Introduction

The buzz in European banking circles last Fall was that if the launch of EMU went smoothly -- i.e. no big computer glitches -- it would augur well for Y2K. Be that as it may, the smooth launch on January 4, 1999 was impressive as banks and many corporations adapted their back-office systems to the new virtual currency. But, of course, even the most ardent Europhiles knows that January 4 marked one small step on a long and bumpy road and that there was considerable disagreement about the final destination.

What I would like to do in this brief presentation is to highlight the main issues in the debate over the bumps in the road -- though some would reject this metaphor as far too mild and would suggest chasm or canyon as more appropriate. And then I will turn to the destination issue: is EMU primarily an economic or a political project? In conclusion I shall raise some of the international implications of EMU.

The Pros and Cons of EMU

First, the case for the defense. One advantage of the Euro is to reduce the transactions costs of trade among the EMU countries by eliminating the need for purchasing and selling foreign exchange. But most economists agree that this cost reduction is unlikely to be consequential. Much more important than this static effect is the dynamic change catalysed by this final stage of economic integration. The creation of Euroland will foster major and ongoing restructuring of industry which should significantly improve business competitiveness. Indeed the process of merger and de-merger has already begun. The "news" of the EMU was not the headlines of January 1999 but the agreement reached in Amsterdam in June 1997 which markets interpreted as ensuring a fait accompli. In addition, the timing of EMU coincides both with increased competitive pressures in global markets and European deregulation in telecommunications and energy. The combined effect of these forces is formidable.

The increased transparency engendered by a single currency increases the power of consumers and the competitive pressure on industries which produce transportable commoditized products. This enhanced rivalry will drive some firms out of business and force the others to restructure to preserve profit margins, i.e. to capture economies of scale and scope. The result should be higher productivity in European manufacturing. And this beneficial shift to consumer power will be greatly magnified as electronic commerce takes hold.

But perhaps even more important will be the impact on the service sector, especially on financial services. In Europe, by and large, the financial sector is either local or global and the EMU creates for the first time a Euroland market about the size of the U.S. Of course much remains to be done in removing regulatory impediments but few doubt that the Euro financial market will be transformed, especially in corporate bonds. Indeed, growth in the bond market denominated in Euros has already grown from 8 Billion in 1997 to 59 Billion over the last nine months of 1998. The impact on equity markets will probably be less spectacular over the short-run but overtime the impact of, for example, diversification of pension funds and the demand for IPO's by small and medium enterprises will transform European equity markets. Since more efficient financial markets improve productivity in nonfinancial sectors, the overall benefits should be considerable.

So goes the case for the pros. The rosy scenario has been under consistent and considerable attack by many prominent exports -- mostly but not solely, American. The reason why EMU is a bad or even dangerous undertaking rests, au fond, on the assertion that imposing a single currency on a diverse group of countries will deprive individual economies of the shock absorbers necessary to deal with local and regional economy problems. This is the "assymmetrical shock" argument and it has been put most forcefully by Martin Feldstein of Harvard and head of the NBER. As he points out, with a decline in aggregate demand neither real interest rates nor the real value of the currency can decline nor can discretionary monetary policy be utilized to reduce the adverse unemployment effect. The ensuing disagreement among member countries about the role of the European Central Bank -- with high unemployment countries pushing for a lowering of interest rates -- would lead, he argues, to increased conflicts within Europe and would encourage the far-right nationalists and for the anti-Americanism latent in many European countries (especially France). The rise in unemployment and stagnant growth would also for protectionist pressures. And worse things could happen, but I don't have enough time to describe them. You can read it all in the December 1997 of Foreign Affairs under the title "The Euro and War"!

While few Eurosceptics are as pessimistic as Feldstein, there are a number of serious concerns now being widely debated by economists and others. The "assymmetric shock" argument cannot be dismissed and in order to mitigate the negative economic and political fallout a number of options are being explored. In federal countries like Canada and the U.S. automatic fiscal stabilizers offset the impact of the rise in regional unemployment. In addition, labour mobility, more in the U.S. than Canada, will over time reduce the regional differences in unemployment. In the E.U. the stabilization funds don't exist and, except for the most highly educated, labour mobility is very low because of language and other barriers.

One way of dealing with this would be to increase the availability of fiscal offsets in the E.U. budget. That would not be easy, especially since with the entry of new members from Central and Eastern Europe, the expenditures on CAP (the Common Agriculture Program) will explode. Beyond the assymmetry case, there are other serious flaws in the basic design of the EMU institutions. The Economist, for one, has argued that the inflation target of the ECB is too low and thus monetary policy will be too rigid. Further, the fiscal conditions required by the Growth and Stability Pact are far too strict and rigid. They require governments to stick to a 3% deficit target except when annual GDP falls 2% or more. But few recessions involved such a steep fall yet all cause rising unemployment. If some easing of fiscal policy is precluded (whether by automatic stabilizers or discretionary easing), the result could be persistent and growing unemployment. Many economists have argued for a revision of the Pact as the only way to cope with this systemic deflationary bias. This will, in turn, make far more difficult the micro reforms which are essential to improve flexibility in labour and other markets in many European countries. So what is needed, in effect, is a move to a form of "economic government" which would permit an effective coordination of monetary, fiscal and micro policies. But a redesign of EMU would depend not on economic arguments but on the politics of Euroland which gets us to the destination issue.

EMU: A Political Project

The ongoing economic integration of Western Europe was seen by its founders as a means to an end -- the political integration which would preclude any repeat of the wars and agony of the 20th century. The integration has proceeded in fits and starts over the past 40 years but the pace hastened in the 1990's with the Single Market project and now EMU. Perhaps it's impossible to disentangle the economics and politics of integration: after all Schumpeter noted wisely that policy was the outcome of politics. And as suggested above, some form of economic government will be required if EMU is to operate effectively. Economic government will involve, at a minimum, some adaptation in the modus operandi both of the ECB and Ecofin, the Committee of Finance Ministers. Further -- but this lies outside our present topic -- the growing criticism of the so-called "democratic deficit" and the need for reform to accommodate new members from Central and Eastern Europe -- will certainly require some redesign of the entire current institutional architecture.

None of these changes will be easy of course. And there's a curious paradox which needs underlining. The current economic design of the EMU was driven by the Germans and the model was the Bundesbank and the fervent attachment to fiscal rectitude espoused by its current President. The French staunchly stood by their German partners. Yet a funny thing happened on the way to the Euro. In June 1997 a Social Democratic government was elected in France and in October 1998 a Social Democratic Government (in alliance with the Green Party) took over in Germany. By next summer there will be a new President of the Bundesbank who is unlikely to replicate its current head in policy propensities. What is not clear -- at least to me -- is whether these dramatic political changes since the 1997. Maastricht meeting will facilitate or make more difficult effective reform or, indeed, do neither but instead seriously increase the tensions threatening to weaken the functioning of the new system.

These are important, if unanswerable, questions not just for the future of Euroland but for the global economy and the global polity. On the economic front it seems clear that over time the Euro will become a reserve currency that challenges the supremacy of the dollar. This will not happen immediately, of course, but the Euro market will be far more liquid than the DM or FF were and the Euro-zone is about the same size as the U.S. economy. One question that has been increasingly raised is whether the global economy will consist of two currency blocs or whether the arrival of the Euro will catalyze a movement to other regional currency arrangements. In Latin America Domingo Cavallo, the former Argentine finance minister, has been pushing for a dollar zone. The Brazilians have been cool to the idea but the present crisis may change that. What will Canada do if a dollar zone eventually is proposed as part of the Free Trade Agreement of the Americas (FTAA)? Judging from recent statements by the Governor of the Bank of Canada the answer would be "thanks but no thanks".

There are also important international economic policy implications stemming from EMU. Will the G-7 still include Governors from member countries or just the head of the ECB? In the absence of effective macro coordination how will fiscal policy discussions proceed? On the trade front the Treaty of Rome assigned power to the Commission and under its current leader, Sir Leon Brittan, the E.U. has played an active and positive role. If the EMU architecture is not reformed and growth stagnates protectionism is the likely result. The WTO bicycle has to keep rolling or it will fall down. So the international stakes are high.

Nor is it possible to de-link international economic policy from foreign policy. One of the concerns of many American critics is that a move from a unipolar to a bipolar world will increase transatlantic friction and create serious tensions as, for example, already manifest in the never-ending Balkan turmoil. But perhaps the real problem is not the latent anti-Americanism some see but the weakness of the E.U.'s institutional arrangements for foreign policy coordination. While the Ecofin promises to get stronger, the foreign ministries' General Affairs Council is near-to invisible. This creates a dangerous disconnect between two policy domains which in a post-cold war world are increasingly intertwined.

So, after all this, what are we to conclude about the impact of EMU on Euroland, the global economy and polity, the U.S. and Canada? In my view, the first step on the long road will create an irreversible momentum to deepening economic and political integration in Europe. The project is too important to fail. For Canada a bipolar world should be welcomed since -- contrary to the views of Feldstein et al -- it is likely to lead to greater, not less, stability. And to allow more space for middle powers like Canada to play a role. This would be true at any time but especially now when the new global power in the 21st century will be China. But that's another story.