The Brave New Euro World

0 Comments | Insight on the News, May 3, 1999 | by Charles A. Cerami

Success or failure of the new single European currency will have significant implications for the economy of the United States, as well as for the rest of the world.

When the euro, the new currency of the European Union, was introduced Jan. 1, the European Central Bank pegged the rate of exchange with the dollar at $1.18, not the expected $1.20. By February the exchange rate had slipped to $1.11 and, as Insight went to press, it was $1.07, a rate that head central banker Wim Duisenberg did not anticipate.

European officials talk as if this is not a worry. "The Governing Council does not regard current monetary trends as constituting a signal of future inflationary pressures" said Duisenberg April 8. Privately, however, officials tell Insight that each day's trading makes them ask, "Why is it sliding?"

When the euro was being phased in by 11 of the 16 countries of the European Union, or EU, the new money was conceived as the tool of a political strategy to make trade in the European countries like that of a single nation. The conventional wisdom was that the euro could become either a great partner, taking some of the pressure off the dollar as the world's overriding reserve currency, or a competitor that would strip the United States of some huge advantages that the dollar's primacy has brought. But there is a third scenario, unspoken for the most part: The euro might collapse, leaving the basket of separate national currencies.

The stable dollar-euro relationship envisioned in the first scenario could turn out to be an international stabilizer, helping steady the portfolio of stocks and bonds held by Americans, for example. And if the euro were to outperform the dollar, it might actually help U.S. exports while raising the price of many consumer goods, as well as the cost of interest on every loan. But neither outcome would be as dramatic as a failure of the new currency.

More than likely, currency traders say, the decline of the euro reflects nothing more than a composite of declines by the German deutsche mark, the Italian lira, the French franc and other EU currencies against a surging dollar. But the question that must be answered during the coming year is whether the survival of the euro depends on its value or on how well each country in the bloc gets along in conforming to the economic straitjacket it assumed when joining the euro group. The concept of the euro is founded on a contradiction -- that each country will keep its sovereignty while actually giving up its No. 1 instrument of economic sovereignty, control of its own interest rates.

As global-market analyst Alexei Bayer says, "The United States runs a single budget deficit or surplus, while our states are required to balance their budgets. In Europe, the Maastricht Treaty obliges member states to limit their deficits to just 3 percent of GDP [gross domestic product] in order to become members of the currency group; but once in, there are few safeguards against profligate national spending. This could allow one nation to live well beyond its means at the expense of its neighbors, who will have to curb spending or raise taxes to support the common currency."

Bayer also points out that European workers have far less mobility than U.S. workers. Rather than seeking work by moving to a new region which might be in a different country with a different language, out-of-work European workers are much more likely to seek higher welfare spending from their own government. European unemployment ranges from 9 percent to as high as 18 percent in Spain. If Germany should have a boom, while others, say Italy and Portugal, fall into a slump, political tensions could bust the euro apart.

Martin Feldstein, who was chairman of the Council of Economic Advisers in the Reagan administration, sees the political bomb as the chief threat to the euro. "Without tough standard-setting by the German central bank, the process is likely to drift to higher inflation rates" he cautions, citing "the mistaken hope that an easier monetary policy would have favorable long-term effects on employment and growth.... How Germany responds to the conflict caused by rising inflation will be a critical issue in Europe's political future."

A team of economists at Prudential Securities, after a technical study, sees the issue in similar terms. They tell Insight: "Our view is that the euro will ... eventually be tested. At some point, one or a few member countries probably will fall out of line with the restrictions of monetary union. If the euro can survive that test, its prospects will be good [in the] longer term."

Will the euro survive as a permanent alternative to the dollar in world trading and finance and a threat to the dollar's dominance? The British pound, for example, has been quoted at about $1.60 for years without it being considered a threat to the dollar. But other countries no longer think of the pound as a reserve currency. A stabilized euro could be different because it represents a large bloc with a larger population than the United States and a GDP nearly 80 percent as large. The Bank of China, which holds $146 billion in hard-currency reserves, announced in advance that it would move some of its holdings into euros. At the present time, however, 57 percent of the reserves held by the world's central banks are in dollars. That preference for the dollar is the chief reason why the United States has been able to sustain a trade deficit of imports over exports of more than $200 billion per year. The possibility of a dollar glut, which would send the value of the dollar reeling, is averted because the foreign national banks find the purchase of U.S. Treasury securities attractive and stabilizing. The United States, in effect, is living on money borrowed from foreigners and is paying them well in interest for the privilege.