Is the euro a sustainable world currency? The 5 magic corners of the magic square - 01.12.2000

Miami University, Differdingen - 30 November 2000
      

Introduction.


Before we discuss the external performance of the euro, let me make sure that we agree on its nature. On the first of January 1999, the miracle happened: 11 European countries agreed to replace their national currency with a common one, the euro. Financial markets did not believe in this event before February 1998, 10 month before the deadline (Illustration 3). Soon, there will be 12 members of Euroland and the national bills and coins, considered for long as the symbol of national sovereignty will definitively be a thing of the past.

Many people still do not fully understand the scope of this event. National denominations are only images of the euro: the Luxembourg franc, the German mark, are the same currency and mere signs of the euro. One can trade and travel from one country to the other forgetting about exchange rate fluctuations (with purchase and selling prices). They have been replaced by fixed conversion rates of 6-significant figures (Illustration 14a). The euro is today our currency and can be used indifferently with national currencies. For international payments, the euro has become easier and cheaper to use although bank charges are still high for trans-border payments. Soon, people will have forgotten what it was to have to change currency all the time and wonder how it was possible for Europeans to have managed so long without the euro (video).

The classical 4 corners of the magic square.


Before analysing the position of the euro on the international scene, let us briefly look into the other 3 corners of the magic square of sustainable monetary policy: growth, employment and internal price stability.

Growth: Euroland's growth rate is 3.4% for 2000, staying above 3.0% for the next 2 years. This result is much better than in the past and in line with the average growth rate in industrialised countries. It is


due to healthy internal demand and exports (private demand expected to grow by 2.75%) supported by employment creation and tax cuts(tax load is between 40 to 60% in Europe compared to 30% in the USA). Note also that growth is highly satisfactory in Euroland's smaller countries and regions that were backward in the past, while the « European locomotive » i.e. Germany is currently the worst performer, improving hereby the regional income in the EU. The ceiling in EU's growth, however, could well match the US's lowest growth projections. It is furthermore unclear to what extent today's EU performance is a temporary after-effect of the past slump and the euro-devaluation or whether it can be sustained despite a slump in the USA.  

Employment: Increased significantly with the average unemployment rate falling from 10.8% in 1998  to 8.5 % in 2001 and expected to decrease further to 7.9% by 2002 (Illustration I ?). This remains above the 4.7% in the US and 4 to 5 % in non-euro countries.

Clearly, for growth and employment to achieve satisfactory levels, further structural adjustments are necessary without indication whether socially, Europeans are prepared to accept the additional initial hardship. Could it be that the multiple currencies were not the last obstacle to a real Single Market? Will France, Germany and Italy manage to restructure their pension funds, for instance? It will take national and regional governments considerable political courage and a lot of explaining to European citizens to push through these essential reforms.  


Internal price stability: On this score, performance has been outstanding with inflation converging to levels around or below 2% over the past 3 years (Illustration 7a). Country differences remain within manageable limits although a few countries are under close surveillance (Ireland, Netherlands, Greece). These results, however, remain better than those outside Euroland and must be seen in perspective with the past levels of divergence.

The contribution of the independent European Central Bank should here be recognised. A word of caution is appropriate however, because the past trend to limit public spending  is apparently eroding. The ECB may not succeed in raising interest rates sufficiently without threatening GDP growth.

Although Europe may still need to have to convincingly demonstrate its capacity to stem inflation also in periods of rapid economic growth, bye and large, the euro has been a success on this score. It resisted well to a series of asymmetric shocks: the Belgian dioxin crisis, the damage from storms in France, etc.... Europe managed to rid itself from the exchange rate misalignments among « strong » and « weak » currencies that plagued trade. Although short term exchange rate fluctuations may be easy to offset by hedging facilities offered by banks, one should not forget the detrimental effects of the excessive variations in periods of crisis that are now a thing of the past (Illustration I1). The euro has also proven to be a formidable revelator of remaining distortions in Euroland to correct and preliminary measures are being taken, such as for instance in the field of tax harmonisation.  


/***External price stability.

This is the part of the euro-story  that has received the greatest publicity as it dropped from 1.18 EUR/US$ on 1/1/1999 to about 0.84 EUR/US$ over 2 years. The problem, however, is largely misinformation. European and national officials launched the euro with excessive pretension as if it were a totally new currency and ignoring its past. They imprudently claimed that it would be a strong currency, ignoring the danger of misalignments that such a claim would create. The world wants foreign exchange stability. The press, particularly the Anglo-Saxon one has enjoyed amplifying these errors.

Let us look at the facts. First, what is the proper reference point? There are 3 ways of looking at this issue. One can take a single point in time, say the first of January 1999. In a floating exchange rate system this approach is clearly inadequate.

Secondly, let us look at past trends. If we integrate the exchange rate variations of the ECU, that the Euro succeeded at the rate of 1 to 1, then we note (Illustration 15) that the drop is steep, but:
 The drop started in 1994/95, when high interest rate on the German Mark started to fall ; and,
 The average exchange rate of the EUR/US$ over the last 15 years is 1.1EUR/US$.  
 Past falls have been steep
 The lowest level was reached in 1985 at 0.744 EUR/US$.

These fluctuations can be related to past changes in interest rates between the USA and Europe. The rise of the ecu above parity with the US$ until 1995 can be related to the high interest rate of the DEM imposed by the Bundesbank to finance the economic recovery of Eastern Germany after
1989. Short-term interest rates in Euroland dropped below those on US$ in 1995, offering one explanation of the turn around of the trend in exchange rates which were simply prolonged under the euro-era. Because US$ are in high demand as a consequence of the USA trade deficit and the active purchase of American firms by European ones, the euro remains naturally depreciated.  


One should also recall that the British Pound, which was traditionally following the US$ (Illustration 4a) is no longer included in the euro, hereby exacerbating variations. This isssue is important in Robert Mundell's perspective of overlapping alliances to avoid wars.

Thirdly, one can approach the issue through the «legal » or "historical'" relationship between the Euro and the US$. The first European Unit of Account (EUA) was created in 1950 to facilitate distribution of the Marshall Plan. Logically, it was given the same weight of gold as the US$ and had therefore the same value. This relationship was carried forward into the Unit of Account (UA) created in 1962. Thereafter, the ECU in 1979 and the euro in 1999 succeeded each other at parity (Illustration I2). Hence, one could take the 1 to 1 relationship between EUR and US$ as reference. In this case, the variations have remained within a range of +/- 15%.

These explanations should not be construed as a support for the euro's depreciation on the foreign exchange markets. First, I hope that the Europeans will not, like the Americans in the past see the position of their currency on the international exchange markets as a " problem of the rest of the world". If Europe is to share world leadership, it must refrain from adopting "European fortress" policies and instead keep its tradition of both internal and external solidarity. Competitive devaluation sends unemployment to the weaker developing countries, impairing their development capacity.  It also brings only temporary relief inside a nation and delays necessary structural adjustments. Hence, Robert Mundell is right to call for central bank interventions to restrict the euro/US$ fluctuations. Whether his limits (1.20 to 0.90 EUR/US$) are realistic, I cannot say. Promeuro feels that in a first stage, these fluctuations should be restricted to +/- 15% around parity.  

It is of course premature to establish the euro's international credentials: it took 20 years for the US$ to overtake the British £ as a reliable international currency. However, the euro bond market is in terms of volume as from year 1 already matching that of the US$ (in 1999, 531 billion US$ equivalent as compared to 550 billion US$ equivalent in US$), which is not surprising considering that: (1) the propensity to save in Euroland (21.9% of GDP) is higher than in the US (17.4 % of GDP), (2) already the ecu market had become in 1992 the third largest bond market in the world after that of the DEM and the US$, and (3), the share of world reserves in euros is far less than its share of international trade.


Also, the euro has already been and will definitively become a major stabiliser of the international monetary system. As Alain Prate, former Vice-President of the EIB, wrote in 1987: « One cannot conceive a lasting reform of the international monetary system if Europe maintains (then) 11 separate
currencies ». The recent joint interventions of the Central Banks are indicative of a new world-order made possible by the euro.

What will make the euro rise or fall further in the coming years, is the decision of the UK to join or not, the impact of the entrance of new less prosperous countries in Euroland, the US balance of payment overhang, and, most importantly the political evolution in Europe.  


The Political Factor : the 5th Corner.


A currency on the foreign exchange market fluctuates like a stock on the stock exchange: not only does its financial/economic performance matter, but also its management, its vision of the future, which translates for a currency in the credibility of its politicians and their long term vision for the nation.

In this regard, performance has so far been dismal, but signs of improvement appear on the horizon. When one takes the 4 corners of the magic square (Illustration X), one notes that they are not managed by the same authorities. Monetary policies and foreign exchange matters are managed - directly or indirectly - by the ECB at a European federal level, while other closely related economic and social policies are still very much in the hands of national or local governments. Traditionally, European workers have been able to claim higher salaries without equivalent gains in productivity because governments were compensating by devaluating their currency and transferring the problem abroad. Admittedly there is the Stability and Growth Pact, but initial indication are that public spending and excessive public debt are not continuing to decrease as initially planned. It will take time for European citizens and politicians to respect their duties as holders of an international currency.  

Furthermore, the European institutions, with the exception of the ECB and the European Court of Justice, are still more a mosaic of national interests than the protagonists of the broad European interests. In international fora, Euroland has still not its single representative; national interests too often dictate the EU representatives' decisions; the principle of subsidiarity is interpreted only to limit


EU authority, as Europe's position in the Balkan war, the recent crises in the energy, transport and food health sectors only too clearly revealed.  

The problem stems from the people's perception that they remain primarily citizens of their own country rather than of Europe (Illustration 9) as they control more tightly their national representatives than European leaders and it will take time to shed their behaviour of hanging onto their local
politicians like in the Middle-Ages the serves accepted the Baron's protection despite their loss of liberty it entailed. The limited number of consumers that have adopted the euro and understand its implications is a problem (see conferences of 13/XI/2000).

PROMEURO believes, however,  that the euro will change that perception and that once Europeans hold the same currency in their hands, that trading between Germany and France is like trading within Germany or France, then they will progressively start to perceive their allegiance mainly to Europe rather than to their national citizenship. Surveys show that a majority of citizens prefer the euro to their national currency (Illustration 10). "The euro will symbolise in Europe the feeling of belonging to the same community". Already a number of recent decisions on tax reforms, unification of railways and flyways, suggest that European leaders may have finally got the message home: if sovereignty is a matter of power, Europe has no other way to avoid becoming an underdeveloped nation but to unite politically. All European monetary unions of the 19th century that were not accompanied by political unions proved unsustainable. Europe has no choice but to become a federal state. The sooner the better, for the euro, for Europe and for world peace.
            Jean-Jacques SCHUL