In the midst of the worsening Asian crisis over recent months, European progress in moving ahead to establishment of a single monetary system, the European Monetary Union, has been driven from public notice in the U.S. That is ironic. For after the considerable uncertainties of recent years, the EMU's inauguration on January 1, 1999 finally looks assured. It very much looks like a full 11 countries will be in from the beginning.
Favorable Conditions for Unification
The Maastricht budget deficit target of a maximum of 3 percent, recently seen as an extraordinarily ambitious condition for membership, has been satisfied almost universally. Greece is the sole exception. And only three countries, the United Kingdom, Denmark and Sweden, for a variety of largely domestic reasons, have seemingly opted out before the May formal specification of membership. These fiscal efforts have been matched by very low inflation rates throughout the region. Interest rates have converged impressively.
But it is more than successful attainment of such convergence criteria that has been behind the march to unification. For one thing, the relative weakness of the Deutschmark and other European currencies in recent months as the dollar has strengthened have provided a more favorable base for a single European exchange rate. This gives promise of favorable initial conditions.
For another, the European economy has shown signs of recovery from its woes of recent years. To be sure, unemployment remains high, demographic change threatens retirement arrangements throughout the region, and government expenditure remains high, but there are favorable indications for something more than a temporary recovery. Earlier predictions, before the full Asian problem had evolved, put expected growth at around 3 percent. It will probably now be lower. But the key point is that this expansion is expected to continue a process of reform that has begun and therefore to have greater permanence.
Key Policy Issues
Leadership of the ECB
There are still important matters to be determined. A key one is the policies and leadership of the new European Central Bank. Clearly, at the beginning, precisely in order to establish its credibility, the institution will have to follow a stricter monetary policy than otherwise might be necessary. That is exactly why fiscal discipline is so essential at the start. Loose fiscal policy in any large country would require even more monetary restraint. That would mean higher interest rates and a lesser level of investment. A significant slow-down in real growth, as much as inflationary pressures, would weaken the initial political commitment to monetary unity. That reality, and the current dispute over initial direction of the ECB, create some real doubts. Fortunately, slower real growth may make the accommodation easier.
Establishing EMU Exchange Rates
A second, and more modest, one is the determination of bilateral EMU exchange rates. There has been some debate among three different alternatives. One is simply to accept the final rate in effect on December 31, 1998. A second is to use the average rate over some still unspecified period prior to the May 1998 meeting that will select member countries. A third is to use the central rate of the prevailing exchange rate mechanism at the May meeting.
Opinion has seemingly now moved in favor of the latter. Its crucial advantage is credibility. Rates have already stabilized around the ERM fluctuation bands of +/- 2.25 percent. They are currently operative, whereas any historical period, as in the average rate approach, introduces some gains for one or another country depending upon the length of time chosen. Waiting until the final moment has progressively lost favor. Speculation and competitive currency manipulation by national authorities during the interim seven months could prove to be destabilizing rather than equilibrating.
A third area, where the EMU potentially could serve as a major catalyst for reform, relates to the labor sector. As mentioned earlier, a high unemployment rate since the 1970s has been a distinguishing feature of most European economies. Real wage flexibility has been about one-half lower in the EU than the U.S. Labor mobility has also been even lower across and within the European countries than within the U.S. If the EMU stimulates efforts to eliminate rigidities and to increase flexibility, the consequences could be quite important for future expansion.
Role of the Euro
Creation of the EMU, potentially, thus goes well beyond creation of a single currency and elimination of the transfer costs in moving from one to another currency. We have already seen the extraordinary effects of the Maastricht criteria upon deficit policy in a number of countries. Extrapolating this process to encompass effective labor reform as well could result in much higher growth over the next decade.
In that kind of situation, there would be increased international demand for the euro as a reserve currency and its greater use as a unit of account in trade flows. That greater presence in international transactions would be paralleled by greater European capital flows and political participation.
Nonetheless, there is little need for U.S. concern. Any shift will be gradual, and in the short run, conceivably offset by larger than normal holdings of dollar reserves by the European Central Bank. Over the longer term, the important and determining factor for euro demand is the performance of the European economy. A boosted and continuing robust rate of growth would serve as an important stimulus for its expanded usage. But that is a win-win world for all.
In the United States, we have been focused on the short-term problems of Asia. Perhaps it's time to give some thought to the medium term evolution of Europe.
This article has been reprinted from the January 31, 1998 issue of EuroWatch. Copyright (c) 1998 WorldTrade Executive, Inc., P.O. Box 761, Concord, MA 01742, USA.