April 30, 1998

Commentary

Making the Euro Work

By ROBERT MUNDELL

The European Council will meet tomorrow in London to announce its final decisions regarding which countries are eligible to proceed to European Monetary Union, and Saturday the selected countries will meet in Brussels to implement the decision. The designated countries will lock their exchange rates to each other on July 1, 1998; the European Currency Unit will become the euro on Jan. 1, 1999, when the process of replacing national currencies by euros within banks will begin. On Jan. 1, 2002, the circulation of euro banknotes and coins will begin, and six months later, the legal tender status of national banknotes and coins will end. By the middle of 2002, the technical transition will be complete.

Much sooner, though, EMU will impose a fundamental change in the monetary policies of its members. A single currency implies a single policy. In the transition period when national currencies and euros are both in circulation, the money-creating powers of the national central banks will be transferred to the authority of the European Central Bank (ECB).

When EMU begins, balance-of-payments equilibrium among its members will be automatic. A country in deficit will experience a decline in its money supply, which reduces spending and corrects the deficit; conversely, a country in surplus will experience an increase in its money supply increasing spending and eliminating the surplus. A monetary union makes use of exactly the same balance-of-payments adjustment mechanism that applies between regions within a single country.

A monetary union will of course have to be concerned about the balance of payments of the union as a whole. A common mistake is to think that floating guarantees balance-of-payments equilibrium. Even if the ECB eschews intervention in the foreign exchange market, balance-of-payments surpluses or deficits will appear whenever foreign central banks accumulate or run down euros. Because in the long run the euro is likely to be widely used as a reserve by central banks, the European Union should expect eventually to get into the same situation as the U.S., with a chronic balance-of-payments deficit fully financed by euro accumulation abroad.

Stroke for Fiscal Prudence

A monetary union (like a currency board arrangement) removes a major source of macroeconomic instability by barring central bank financing of fiscal deficits. To the extent that governments will no longer be able to run up large public debts and force the central bank to inflate their burden away, it will be a big move in the direction of fiscal prudence.

There are, however, two moral hazard problems that will probably be aggravated by monetary union. They revolve around the two types of risk faced by bondholders: currency and default risk. These risks give rise to higher government bond yields. Whether currency or default risk is more important depends both on the exchange rate system and on the incentive for default.

Government default risk can be measured by comparing the yields on government and top-grade corporate bonds denominated in the same currency. Government default risk appears when the yield on government bonds rises relative to corporate bonds. Near the eve of EMU, Belgium and Italy, the two countries with the highest default risk as measured by the ratio of debt to gross domestic product, had higher yields on government bonds, relative to top-grade corporate bonds, than most of the other EU members.

Currency risk appears in interest rates much earlier than default risk does. By contrast to default, little obloquy is attached to inflation or devaluation. Markets therefore expect depreciation long before default risk has appeared strongly. Because the currency risk premium in interest rates is an early warning indicator of unsustainable monetary or fiscal policies, and because monetary union removes currency risk, countries will be relieved of an important constraint on fiscal deficits. The removal of currency risk creates one moral hazard problem associated with EMU.

But there is also a moral hazard problem associated with default risk. With all EU public debts denominated in euros, there will be one colossal bond market, close to if not greater than the U.S. government bond market. Government bonds will still have a certificate of origin, of course, and some countries will persist in illegal protectionist measures barring all but national bonds in insurance portfolios, but by and large government debts issued by different countries of the same maturity will become almost perfect substitutes. Default by a member state would be a political catastrophe for the union; the market will persevere in the belief that when the chips are down the union will act as lender of last resort. This will further weaken the imperative for fiscal adjustment.

The free-rider problem associated with the reduction of currency and default in a monetary union made recourse to some element of centralized control necessary. Hence the Stability and Growth Pact, which will penalize with fines countries that have tolerated excess deficits. With a debt-GDP ratio for the EU at 72% today (it was less than 60% when the Maastricht Treaty was signed in 1992), the stability pact penalties will have to be imposed rigorously. While some allowance has to be made for countries in recession, penalties should be as automatic as possible in order to avoid the intraunion political pressures that are bound to accompany discretion and majority voting.

Monetary policy will have to take into account several liquidity effects associated with the introduction of the euro. First, there will be a one-time liquidity effect associated with the replacement of national currencies by euros. The replacement of the total stock of national currencies by euros will increase total liquidity. This is because a euro, with a larger transactions domain, will be more liquid than any of the currencies it replaces. When, say, 500 billion euros worth of national currencies are replaced by 500 billion euros, European liquidity will be increased just as if there had been a sudden increase in the European money supply. ECB monetary policy will have to be tighter to take account of this factor at the outset.

A similar effect will be experienced in the bond market. Like all assets, bonds have a liquidity dimension. With the redenomination of national debts from local currencies to euros, the liquidity of this debt will be larger than the liquidity of the combined national public debts and the transformation is bound to create a revolution in world capital markets.

The centralization of reserves involves liquidity effects associated with the three main types of reserves: foreign exchange held in European currencies, foreign exchange held in non-European currencies (mainly deutsche marks) and gold. Pooling foreign exchange held in marks and other European currencies will reduce net reserves of Europe. Once EMU is formed, intraunion deficits and surpluses will be netted out, and reserve needs for the union as a whole will be considerably smaller than the sum of the reserve needs of individual members.

If external (mainly dollar) reserves were at an appropriate level before the union, they will be excessive after it. The same holds for gold reserves, of which the EU countries hold almost half the world's monetary reserves. Any immediate action to dispose of the part of these reserves that are considered excessive would be damaging to exchange rate stability and a suitable subject for international coordination.

A related factor is the change in need for reserves of the European System of Central Banks. After it has been successfully launched, the euro will itself become a reserve currency of choice for many countries around the world. Europe will now benefit from the "exorbitant privilege" to run a "deficit without tears." Reserve currency status is a kind of widow's cruse that keeps the owner in perpetual liquidity. Judging by the past experience of reserve centers, which have frequently got by on negative net reserves, Europe will be able to float its own IOUs to pay for future deficits as they might arise.

The liquidity factors suggest that in the transition phase there will be excess liquidity that could lead to inflation. Over the longer run, however, this danger of inflation has to be set against the demand for euro reserves on the part of the rest of the world. There is bound to be a large and growing demand for euros to hold in central-bank accounts that will eventually more than make up for inflationary liquidity factors inside Europe. Because the external demand will take time to develop, however, immediate policy should err on the conservative side.

Throughout history the world economy has seen a succession of important currencies that have attained the status of international currencies. Usually these currencies have been associated with great powers in their ascendancy. That was the case with shekels, darics, drachmas, denarii, dinars, ducats, deniers, thalers, livres, pounds and dollars. Five common denominators have been associated with the success of these currencies: a large transactions domain, a stable monetary policy, the absence of arbitrary exchange restrictions and controls, a powerful central state and a fallback value in terms of one of the precious metals.

Size is an index of the currency's ability to act as a cushion against shocks. Just as the level of a large lake will be affected by a falling meteor of given size by less than the level of a small lake, so currencies with thick markets (large transactions areas) are less volatile than currencies with thin markets. The transactions domain of the dollar, based on U.S. GDP, is almost twice as large as its nearest rival, the yen, and four times as large as the mark; moreover, once a currency has become the leading currency, economies of scale and scope set in and its transactions domain stretches far beyond the national boundaries. Because of the international use of the dollar, its transactions domain is several times larger than any of its rivals.

From the standpoint of size, the EU-15 has a population of 375 million and a GDP close to U.S. levels; at current exchange rates, the per capita income of the EU is considerably below that of the U.S. As incomes of the poorer members converge toward the European (and U.S.) average, however, and especially when output is swelled by new members from Central and Eastern Europe, the inner EU area will eventually be considerably larger than the U.S. This is for the future. In the early years, starting with the EMU-11, with a population of 292 million and a GDP around $6.6 trillion, the euro's transactions area will be somewhat smaller than that of the U.S. Nevertheless, from the standpoint of the size criterion, the prospects for the euro are excellent.

The importance of ECB monetary policy can hardly be overrated. No currency has ever survived as an important international currency with a sustained high rate of inflation. But the Maastricht Treaty has built-in safeguards to guarantee stable monetary policy, and it would not only be contrary to the treaty but also socially unlikely that monetary policy would be used to reduced unemployment or reduce embarrassing public debts by "surprise inflation." In this respect, consensus has come a long way since the 1970s.

There remains of course the question of how the ECB's independent "discretion" will be used. Price stability is the object, but because of lags in the effectiveness of monetary policy and the management of expectations, it is not always clear whether monetary, inflation or exchange rate targeting is the best route to price stability. Leading indicators of future inflation include gold prices, interest rates, monetary aggregates and even growth rates. In short, the ECB will have the same problems of monetary management as the Federal Reserve System in the U.S. But there is no reason why it should be less successful than its American counterpart.

The third factor is the absence of exchange controls. Exchange controls are frequently a symptom of a currency's weakness, anathema to the prospects of a currency being successful internationally. But controls are often imposed for political reasons, to enforce sanctions or carry out other elements of foreign policy. Gone are the days when George Washington in the midst of the revolution could draw on his account with the Bank of England!

The fourth factor is the power of the central state, and it should be considered in conjunction with the fifth factor, the fallback value of the currency in terms of its precious-metal components. Note that all the great international currencies noted above were produced by strong central states and, moreover, started as metallic currencies. Unlike paper currencies, they had a fallback value if the state collapsed. If any of the Italian city-states coining the sequins, florins or ducats of the Middle Ages collapsed, the 3.5-gram gold content would make the currency still worth holding. Not so for a paper currency. After the Battle of Gettysburg, Confederates notes became worthless; after Mao Tse-Tung's forces crossed the Yangtze, Kuomintang notes succumbed to hyperinflation.

No Fallback Value

The pound and the dollar achieved their importance first as gold currencies. After the pound left the gold standard, it was phased out as an international currency; after the dollar was taken off gold, Europe intensified its efforts to create an alternative to the dollar.

The euro will be the first international currency to start off without any explicit fallback value in terms of gold or silver, and without the backing of a strong central state. In the abstract these defects seem lethal. But two factors greatly mitigate them. One is that most of the EU is part of a security area, NATO, which protects it from enemies from without. The other is that the EU countries have massive holdings of gold and foreign exchange. These two factors make it possible for the euro to be an exception to the rule.

Nevertheless, there is a risk that should not be taken lightly. I once thought that the best way to create a European currency would be to "Europeanize" the most important stable national currency, rooting the euro in the mark. Politics ruled out that solution. Yet serious policy divergences within the EU would be debilitating to the euro and catastrophic for euro capital markets. Further steps toward policy harmonization and even elements of political union must be on the agenda soon after the euro is launched.

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