Conference: America and Europe: A Time For Unity, A Time For Vision 21-22 Feb. '97

Panel Two: Sharing Hopes and Ambitions: The Economic Agenda (2) "Implications of the Euro"

Executive Summary/Introduction Thirteen of the 15 nations comprising the European Union have committed to establishing an economic and monetary union (EMU) by January 1, 1999 and adopting a single currency - the "Euro" - by 2002 (Britain and Denmark are not bound by the agreement). In doing so, they will surrender a significant degree of economic sovereignty with the expectation that EU-wide price stability will enhance the competitiveness of European goods and services in the global marketplace. This next year is critically important as well, as economic performance during 1997 will determine will be made as to which countries will qualify for initial membership in the EMU. Significant questions remain, however, as to whether the agreed upon timetable is achievable, how many member states will meet the Maastricht criteria, and whether the economic criteria are sustainable. There also is political uncertainty surrounding the EMU as opinion polls continue to evidence public skepticism, particularly in Germany, on the benefits of monetary union and a single currency. Nevertheless, most analysts generally assume that the EMU will become a reality at some point in the next few years. While there has been considerable study of the costs and benefits of the EMU for the European Union states, there heretofore has been very little attention given to the implications of the establishment of the EMU and creation of the Euro for the rest of the world, the United States in particular. What impact would the Euro have on the dollar, exchange rate policy, and international monetary cooperation? The purpose of this panel is to stimulate a frank and forthright dialogue on these issues. It is anticipated that the discussion will proceed along two tracks. During the first half of the discussion, the participants will address the prospects for establishing and maintaining the EMU, especially the extent to which the Maastricht criteria will be liberally construed to accommodate as many member states as possible, as well as the political and economic ramifications if the process fails. The participants should then, for discussion purposes, assume that the EMU will be established and the Euro adopted in the reasonably near future. Therefore, the second half of the discussion will be focused on the impact of the EMU and Euro on trans-Atlantic relations and global markets. In particular, will monetary union and a single currency stimulate growth in the EU? What is likely to be the relationship between the dollar and the Euro? Will the dollar's role as reserve currency be strengthened or weakened? What policy responses, if any, should the United States consider? Wither the Maastricht criteria? The Maastricht Treaty established the timetable and guidelines for accession to the EMU, requiring substantial monetary convergence by the member states. Starting on January 1, 1999, member states' currencies will be linked by fixed exchange rates and the European Central Bank will set monetary policy. The Euro will become legal tender. Member states will thus relinquish their authority over inflation, interest rates, and exchange rates. By 2002, a common currency will replace the national currencies. The coming months are important because the economic performance of member countries in 1997 will determine whether the member states qualify to join the first tranche of EMU members. The Maastricht treaty set four principal criteria for membership in the EMU: Inflation: inflation rates no more than 1.5% above the average of the three lowest-inflation countries. Interest rates: long-term interest rates within 2% of the average of the three lowest-inflation countries. Deficits: annual budget deficits less than 3% of GDP. Public debt: debt-to-GDP ratios of less than 60%. Most attention has been focused on the latter two criteria. As the accompanying chart indicates [see attachment], only two countries, France and Luxembourg, currently meet the deficit and debt criteria. Several countries, including Austria, Denmark, Finland, Germany, Ireland, Portugal, Spain, and the United Kingdom, meet at least one of the two tests and are reasonably close on the other. While it has generally been assumed that five to eight countries will make the initial cut, including Germany, France, and the Benelux countries, prospects for some of the southern EU countries joining has improved. In particular, Italy and Spain have announced their intention to comply with the Maastricht criteria; Italy has recently rejoined the ERM and its budget includes $40 billion in spending cuts and tax increases intended to meet the 3% deficit target. While there is recognition of the substantial progress EU states have made in reducing annual budget deficits and lowering aggregate debt levels, questions remain as to whether there is the political will to take the further steps necessary to meet the Maastricht criteria, particularly against a backdrop of weak economic growth and persistently high unemployment rates. In this latter regard, opinion polls evince considerable skepticism on the part of the general public about the benefits of monetary union. This is especially true in Germany where polls show a majority opposed to the Euro and 80% want the decision on a single currency to be put to a vote. Several key questions are presented: How many countries will meet the criteria, or come within an acceptable margin, by early 1998, when the European Council determines which countries will qualify for the EMU in 1999? Will the criteria be strictly applied or liberally interpreted? Is close acceptable? In this regard, it should be noted that the Maastricht treaty contains some wiggle room if the country is moving in the right direction or if the deficit/debt level is only "temporarily" too high. Will Italy's expressed intention to join the EMU increase pressure to view the criteria more "flexibly"? If strictly applied, will a sufficient number of countries qualify to give the EMU credibility and critical mass? If not, will Germany, which has expressed concern that looser standards will result in a single currency much weaker than the deutsche mark, allow them to be liberally construed? Will states that fail to initially qualify accept a "multi-speed" approach or will they derail the process? Maintaining the EMU - The Stability Pact One question the architects of the EMU have struggled with is how to ensure that member countries, once in the monetary union, maintain fiscal discipline. In order to ensure that the Euro does not become a substantially weakened version of the D-mark, Germany initially pressed for a stringent "stability pact" whereby member countries would face the prospect of automatic fines for failure to meet budgetary targets. Other countries, especially France, expressed strong opposition to the plan proposed by former German finance minister Theo Waigel, preferring instead a political solution to deal with violations on a case-specific basis through a special council of ministers. The EU leaders hammered out a compromise at a summit in Dublin in December. Under the terms of the agreed upon stability pact, fines of up to 0.5% of GDP would be automatically imposed on countries whose deficits rise during periods of economic growth or slight downturns; a special council of ministers would determine appropriate sanctions or actions during more severe economic downturns; and that deficits incurred during periods of significant negative annual GDP growth (2% or more) would not trigger penalties. Implications of the EMU? It is generally acknowledged that the economic and monetary union, if it is successfully implemented and sustained, will have a significant impact on the EU members and could affect trade and economic policies of the United States and the rest of the world. Most observers believe that the impact on member states would be beneficial, although The Economist has opined that "EMU could be a good thing or bad thing depending on how it is done." There is, however, very little consensus among analysts on the implications of the EMU for the United States and its impact on the dollar, in part because there has been remarkably little discussion of these issues in the U.S. and Europe. Given the fact that the EU's population is 370 million persons, the collective GDP of the EU is 20% larger than that of the United States, and a Euro-denominated government bond market could be as much as 30% larger than the U.S. Treasury market, it is clear that the EMU warrants the full and considered attention of policymakers on both sides of the Atlantic. Proponents of monetary union and a single currency argue that a strong, stable Euro will help stimulate economic growth and enhance the power and prestige of the European Union. MIT professor Rudi Dornbusch notes that while politicians have driven the process, finance ministers are anxious to "lock-in" lower inflation and deficits, industry is excited about an expanding European market and lower costs, and leading European financial institutions are looking to become more dominant players in global financial markets. Randall Henning, a professor at American University and visiting fellow at the Institute for International Economics, argues that monetary union would have three likely consequences: Since internal currencies would become fixed against one another, it would further accelerate the growth of intra-European trade. It would eliminate the tendency of fluctuations in the dollar to drive wedges between the European currencies. The Euro will become a principal reserve currency and denomination currency for international business transactions, to some extent supplanting the dollar. He observes that the combined effect of the increase in internal trade relative to GDP, elimination of the dollar's wedge-effect, and the enhanced importance of the Euro will lessen the vulnerability of EMU members to fluctuations in their currencies vis-a-vis the dollar and other non-EMU currencies and strengthen the power and influence of Europe in the global marketplace. Other commentators are not as sanguine. Some are merely skeptical about the prospects for monetary union and a single currency. Others view monetary union as being driven much more by political considerations than economic ones - a paean to Europeanists like Chirac and Kohl who have staked their political careers on making the EMU and Euro a reality. They also note that efforts to meet the Maastricht criteria require states to adopt strict austerity measures that are fueling political unrest and could still derail the process. In this regard, it is worth noting that France and Germany hold elections in 1998 and monetary union will undoubtedly be a major campaign issue. In addition, Robert Samuelson, in a recent Newsweek article, argues that Europe's economic problems stem principally from high taxes, excessive regulation, inflexible labor practices, and costly welfare systems, factors that would not necessarily be affected by the Euro. With respect to the Euro's impact on the dollar, there are two opposing schools of thought. The first is that, at best, the Euro will be a watered down version of the D-mark, and the European Central Bank will lack the capability and intestinal fortitude of the Bundesbank to maintain monetary stability. The result-especially assuming the continued weakness of the yen-will be to actually strengthen the dollar's position as reserve currency. The other school of thought is that the Euro will be a natural and strong competitor to the dollar. In this view, it is not so important that the Euro be as rock-ribbed as the D-mark. As long as the principal EU countries are participating and the European Central Bank maintains relative price stability, other central banks and investors would look to diversify out of dollars-thereby weakening the role of the greenback. Other factors might also contribute to a relatively strong Euro and weaker dollar, including existing European central banks excess dollar reserves that likely would be sloughed off and the enhanced role of the Euro in trade invoicing. In addition to these fundamental questions of the impact on the EU and the United States, there are a number of other rather interesting policy questions posed by the establishment of the EMU and the single European currency that warrant consideration: Is there a further role for the G-7? Should the United States insist on a new structural arrangement, the G-3, with the U.S., Japan and the EU? What impact, especially over the short-term, would the elimination of individual European currencies have on payments systems and the foreign exchange market-and the financial institutions and intermediaries whose profits are derived from trading these currencies? What would be the role of European member countries in the international financial institutions and multilateral development banks? What would be the effect on quotas? What impact might the success or failure of the monetary union have on other important policy matters, such as expansion of NATO and the integration of Eastern into Western Europe, and trade liberalization around the globe?