A primer in economics
Moreover, the broader benefits of a single currency must be weighed against the loss of two policy instruments: an independent monetary policy and the option of changing the exchange rate. Losing these is especially grave if a country or region is likely to suffer from asymmetric shocks that affect it differently from the rest of the single-currency area, because it will no longer be able to respond by loosening its national monetary policy or devaluing its currency.
Optimal currency theory then looks at alternative responses to asymmetric shocks, singling out three. The first is mobility of labour: workers in the affected country must be able and willing to move freely to other countries. The second is flexibility of wages and prices: the country must be able to adjust these in response to a shock. The third is some automatic mechanism for transferring fiscal resources to the affected country.
The theory concludes that for a currency area to have the best chance of success, asymmetric shocks should be rare, implying that the economies involved are on similar cycles and have similar structures. Moreover, the single monetary policy should affect all the constituent parts in the same way (in the jargon, through similar transmission mechanisms). There should be no cultural, linguistic or legal barriers to labour mobility across frontiers; there should be wage flexibility; and there should be some system of stabilising transfers.
It does not take an economics professor to see that none of these conditions is met in the European Union. There are cyclical and structural differences among EU economies, and interest rates operate in different ways. Europe has experienced several big asymmetric shocks in the past decade, including the unification of Germany and the collapse of Finlands trade with the former Soviet Union. There is little or no labour mobility among the member countries, and wages are notoriously rigid. Moreover, there is little enthusiasm for an expansion of the EU budget to allow for big fiscal transfers.
At this point, many economists compare and contrast Europe with the United States, which has a similar-sized economy and population. American regions also suffer from asymmetric shocksTexan oil in the mid-1980s, New Englands property collapse in the late 1980s, Californias defence bust of the 1990s. But at least wages and prices are more flexible, people in search of jobs cross state borders freely and willingly, capital and product markets are more deregulated than in Europe, and the federal government plays an important stabilising role. Calculations in the 1980s suggested that, on average, 40% of any drop in gross state product was offset through higher benefits received from, or lower taxes paid to, the federal authorities.
This optimal currency area theory may sound esoteric, but it is a main reason why so many economists, especially but not only in America, are hostile to EMU. One noted critic, Martin Feldstein at Harvard University, has even suggested that the single currency could lead to war*.
Oddly enough in view of his strictures, Mr Mundell himself seems to take a more favourable view of the euro than many of his followers. This may be because there are practical answers to many of the theoretical objections. The United States is probably not an optimal currency area either, but the existence of the dollar has moved it closer to becoming one. Both the amount of labour mobility and the extent of stabilising fiscal transfers in America may have been exaggerated. One new study suggests that these days only 10% of any fall in gross state product is compensated via the federal government.
Europes shortcomings, too, can be exaggerated. For instance, labour mobility is extremely limited not just between European countries, but within them too; yet their own single national currencies seem to be working perfectly well. Asymmetric shocks may be less common in diversified Europe than in some of the highly specialised regions of the United Statesand they are more likely to hit industries or regions than individual countries, making the exchange rate the wrong adjustment tool. Moreover, asymmetry has often been magnified by different policy responses to shockswhich will disappear once monetary policy is safely in the hands of an independent European Central Bank.
The absence of fiscal transfers is more serious. As long ago as 1977, the MacDougall report advocated a big expansion of the European budget, to perhaps 7% of GDP, to enable it to play a more substantial stabilising role. Alexandre Lamfalussy, the first president of the European Monetary Institute, thinks monetary union will necessitate a much bigger EU budget. But most EU members, under pressure to cut public spending at home, are unwilling to let the budget rise above its present ceiling of 1.27% of their combined GDP.
Meanwhile, however, national fiscal policy remains available (though unhelpfully constrained by the stability and growth pact, see next section). Indeed, given that the public sector as a proportion of GDP is bigger in Europe than in America, national fiscal policies in the EU should have commensurately bigger stabilising effects. Commission officials also draw attention to Article 103(a) of the Maastricht treaty, which would permit an aid package to a euro member that got into real difficulties.
In any case, the arrival of the euro will itself change Europes economy, just as the dollar did Americas. Indeed, the arguments of some of the economics literature are circular, to the point where an optimal currency area sometimes seems to be defined as one that has a single currency. Similarly, the arrival of the euro may make asymmetric shocks less likelynot only by eliminating those that are policy-induced, but also by promoting the convergence of trade and economies.
Economists doubts about the euro also tend to ignore the alternative. Pace some enthusiasts, the single currency is not itself a necessary adjunct to the single market. Yet in an increasingly integrated Europe, the independent use by a member country of monetary policy or the exchange rate is seldom easy to justify. Monetary policy should focus on price stability, as the European Central Bank will be required to do. As for devaluation, most studies suggest that its beneficial effects on competitiveness are only temporary; over time they are eroded by higher prices. Devaluation also causes tensions inside the single market; in 1993, French officials say, France lost nearly 1% of GDP thanks to competitive devaluations in Italy and Britain.
Some of the economic effects of EMU are already emerging. The most immediate impact will be on Europes capital markets, which are likely to become more like Americas. Henry Kaufman, a shrewd Wall Street financier, goes so far as to forecast a new colonisation by Anglo-American financial markets. Banks are likely to lose their prime role in financing industry to the securities markets, which can be expected to develop rapidly. The euro areas bond market will rival Americas, and so will its stockmarkets. Capital market reforms should both reduce the cost of capital and improve its allocation. Some economists reckon that ineffective capital markets are one of the main causes of Europes high unemployment.
How fast will reforms come? Here opinions differ. Some economists reckon that capital markets are quick to change. Already most prospective euro members have announced that both existing and new government debt will be denominated in euros from January 1st. Companies will follow suit. Yet other economists point to the absence, so far, of benchmark bonds. France is already manoeuvring to give this status to its Treasury bonds, though in the long run German government bonds seem a better bet. And there are lots of tax, regulatory and cultural differences among euro countries that will still stand in the way of free investing and borrowing across borders. A genuine single capital market may take some years to emerge.
Even so, European financiers are getting ready. The past 12 months have seen a spate of bank mergers in Europe, including the takeover by the Dutch banking group ING of Belgiums Banque Bruxelles Lambert, a Bavarian marriage of Bayerische Vereinsbank with Bayerische Hypo-Bank, and (outside the euro area) the merger of Swiss Bank Corporation with Union Bank of Switzerland. Continental Europe remains overbanked compared with America and Britain: more mergers, branch closures and job losses are inevitable.
A similar picture is emerging in the insurance industry. Zurich is merging with B.A.T Industries insurance interests, and Germanys Allianz and Italys Generali are fighting over Frances AGF group. And the euro merger mania is beginning to stretch to industries beyond finance. Once prices across Europe are in euros, instead of escudos or Finnish marks, price comparisons will be instantand competition, at both retail and wholesale level, will hot up significantly. That is why industries selling into most European marketssuch as car and drugs makersare all cutting costs and seeking partners in preparation for the pressure the euro may put on their margins.
This should be good both for Europes consumers and their economies, subject to two caveats. One is that some industries might end up concentrated in particular regions or countries, as has happened in the United States. Nobody knows how far this is likely to go, though the single currency will clearly give specialisation a push. If Europe starts to look more like America, the risk of asymmetric shocks may increase.
The second caveat is even more serious. Much of the restructuring that the euro will promote will deliver benefits only if companies can shed labour. Yet this could, in the short run, increase Europes already unacceptably high unemployment. That may explain why European countries remain so unwilling to change labour-market regulations that make it hard to fire (and costly to hire) workers. Comparisons of American and European bank mergers suggest that cost savings are twice as high in America because jobs can be cut more easily.
Yet if labour-market regulation genuinely protected jobs, Europes unemployment performance would be better than Americas, not worse (see chart 3). The evidence is clear: the way to cut unemployment is to deregulate, trim welfare states and cut wages and, especially, non-wage labour costs; not, as Europe has done, to regulate, protect welfare and allow non-wage labour costs to go through the roof.
This raises perhaps the most crucial economic issue of all. The arrival of the single currency makes it more urgent to bring in broader structural reforms to Europes sclerotic economies. True, the single currency is starting at a serendipitous moment, but despite relatively buoyant economies Europe continues to suffer from high unemployment, most of it structural rather than cyclicalwhich the euro on its own will do little to cure, and could conceivably worsen in the short run. The loss of independent monetary and exchange-rate flexibility makes it essential to improve European economies flexibility in other respects.
So the 64,000-euro question about EMU is: will it help to bring about structural changes? Some are sceptical, considering that the two are essentially unrelated. That is why the International Monetary Fund, for instance, has given warning that, without structural reforms, the euro could make Europes economies even more rigid and less competitive. France and Germany have maintained a de facto monetary union for over a decade, yet both have been hideously slow to introduce structural reforms. Indeed France (and Italy) are moving in the wrong direction by seeking to introduce a 35-hour working week.
There is an even more apocalyptic view: that the euro may turn out to be an impediment to structural change. The argument is that EMU, especially the painful process of trying to reach the Maastricht fiscal targets, has been a distraction from more important reforms; governments can give their full attention to only one thing at a time. Yet the implication of this is implausible: that the abandonment of EMU would unleash a spate of structural changes that most governments have so far been too timid to tackle. The reverse is surely more likely: that scrapping EMU would delay structural reforms for even longer.
Hence the third, most robust view of EMU: that it will act as a catalyst for structural change. There is indeed some evidence that this is happening already. Italy and Spain have partially deregulated their labour markets. All European countries, even France, are continuing to privatise state-owned industries. There is a growing consensus that Europes pension problem must be dealt with. In making the single market more competitive, and increasing price transparency, the euro is bound to increase the pressure for change. As Jean-Claude Trichet, governor of the Bank of France, puts it: The single currency is per se a major structural reform.
It is too early to be sure which of the three answers to the 64,000-euro question is correct. What is certain, however, is that Europes governments have done themselves no favours with their design of the Maastricht criteria and the accompanying stability pact. Indeed, the blueprint is so inappropriate that, without changes, it could turn into yet another obstacle to structural reform.
*The Euro and War, by Martin Feldstein. Foreign Affairs, November/December 1997
Redistribution vs Insurance: Does Europe Need a Fiscal Federation?, by Antonio Fatas. Economic Policy 26: Prospects and Challenges for the Euro. CEPR/Blackwell, forthcoming
In a special section, EMU and the World Economy, in the IMF World Economic Outlook, October 1997