ECONOMY FEBRUARY 11, 2002
The euro's launch on January first of this year didn't make the cover of a single major American business magazine. The New Republic's own Andrew Sullivan summed up the prevailing view on this side of the Atlantic: It was a “substantive non-event.” Those who didn't ignore the euro altogether predicted its dramatic failure. George Will declared that it “will not 'work,' even understanding that narrowly as producing economic efficiency.” And National Journal columnist Clive Crook compared Europe's adoption of the euro to Argentina's “adventures in monetary union.” The ridicule was near unanimous.
It was also probably wrong. In fact, the euro's launch could easily prove the most important economic event of the decade. While it may not invigorate Germany's slumping service sector or turn Naples into a post-industrial metropolis, it could solve some of the continent's most deep-seated economic problems and put Europe on a path toward sustained growth. And if it does, the euro's introduction may dramatically alter the balance of economic power between the United States and Europe. In years to come, Americans could even look back wistfully on the first of this year as the moment when world economic leadership began to pass quietly from the United States of America to the united states of Europe.
THE EURO WILL benefit Europe's economies by making cross-border trade and investment a lot easier and a lot more attractive. For centuries, European nations have done much of their trade with each other, but they have been hampered by tolls, tariffs, and competing currencies. And while the formation of the Common Market in 1958 began to knock down trade barriers, it did nothing to eliminate the inefficiencies caused by currency differences: Banks, businesses, and individuals still had to swap currencies—which meant paying transaction costs—to exchange goods and services. In addition, businesses planning investments or contracting for goods in other European nations had to guess whether fluctuating exchange rates would alter the values of their investments or purchases. Every investment entailed a hidden risk. The euro eliminates both that uncertainty and those transaction costs. According to Daniel Gros and Niels Thygesen, authors of European Monetary Integration, the savings could run as high as 2 percent of total GDP—or about $150 billion in 2001.
Moreover, Crook's comparisons notwithstanding, the euro will actually protect the nations of the European Union (EU) from Argentina's fate. Argentina's economy went into a tailspin precisely because it fixed its currency inexorably to the U.S. dollar after joining a free-trade zone, Mercosur, with countries whose currencies were not pegged to the dollar. When Brazil, one of the Mercosur countries, devalued its currency, the Brazilian real, against the dollar in 1999, Brazil's exports became cheaper and Argentina's more expensive. Argentina's trade deficit grew, fueling unemployment and setting the stage for last December's collapse. Thanks to the euro, the same thing can't happen to the members of the EU's free-trade zone—because they use the same currency. Italy, in other words, can't devalue its currency at Spain's expense (or vice versa).
Other critics argue that since the euro countries now share a common interest rate and must limit deficit spending to 3 percent of GDP under EU rules, countries suffering high unemployment during a recession won't be able to use fiscal or monetary policy to stimulate their economies. This ignores the fact that the EU's deficit-spending rules contain loopholes for such an eventuality. But more importantly, it ignores the fact that while this may be a problem, it would have been a problem even without the euro. After all, running deficits to fight unemployment has never been a trouble-free proposition: Countries that did so in the pre-euro regime risked sparking a run on their currency. And the adoption of the euro creates a new way for EU nations to fight unemployment, enabling them to do what the New Deal accomplished for the United States in the 1930s. To combat the Great Depression, the U.S. government used unemployment insurance to transfer income (and consumer demand) from low- unemployment states in the North to high-unemployment states in the Deep South. Similarly, EU economists—thanks to the union's new common currency—are now considering continent-wide unemployment programs that would transfer funds from low-unemployment countries in the North to high-unemployment countries in the South.
BUT THE EURO'S impact will be felt in the United States as well—because it may come at the expense of the dollar. Through the euro, European countries could come to enjoy the power and economic advantage that the United States gained when the dollar became the world's currency. In 1944 the Bretton Woods conference fixed the dollar as the official international currency—pegged at $35 for an ounce of gold—and set values for all other currencies in relation to it. And though the United States abandoned the Bretton Woods system in 1971 and let the dollar float in relation to other currencies, the dollar has continued to function as the main international reserve currency, as well as the most common currency for trade and investment. Countries that do not accept escudos or krona as payment usually accept dollars, and keep dollars in their central bank as a reserve fund in case of a financial crisis.
The dollar's unique status has helped lubricate world trade, but it has also bestowed particular advantages on the United States. As long as countries are willing to keep dollars as their reserve currency, the United States can run huge current-account deficits (about $400 billion in 2000) without being subject to the fiscal discipline that other nations must endure. (The “current account” consists of whatever Americans spend on foreign goods and services—including spending by military and other government operations abroad—minus whatever foreigners spend on our goods and services.) If Thailand, for example, runs current-account deficits in its baht, it has to counteract that through some combination of raising its interest rates, devaluing its currency, and cutting its budget—any of which could cause recession. But the United States can run such deficits without its currency coming under attack because the dollar is the world's currency. Countries don't want to unload their dollars; they want to hold onto them. So while the United States may occasionally face pressures to raise its interest rates or cut its budget, as it did in the late 1970s, the pressures are much less severe than those faced by other countries. As a result, the United States can simultaneously be the world's greatest debtor and its most prosperous country.
Since the 1960s, European countries have bristled at the dollar's privileged position. During the Vietnam War, Europeans worried that the dollars accumulating in their banks were causing inflation and enabling Americans to buy up European firms. Indeed, the United States left the gold standard in 1971, partly in response to French attempts to cash in their dollars for gold. Since then, European nations have gradually taken steps to cushion their national currencies from fluctuations in the dollar. In 1978 German Chancellor Helmut Schmidt and French President Valery Giscard d'Estaing proposed a European Monetary System that would fix the value of European currencies in relation to each other; in 1992 the EU countries decided at Maastricht to launch the European Monetary Union and the euro; in 1999 the currencies of all the EU nations became convertible to euros at a fixed rate; and this year those currencies were replaced by the euro.
Americans may be oblivious to a threat from the euro, but Europeans envisage it eventually rivaling or even displacing the dollar as the world currency. In a typical article last month heralding the “coming of Europe,” Die Zeit economic columnist Wilfried Von Herz looked forward to the euro becoming the international “key currency.” To be sure, that's not likely to happen anytime soon. Today only about 13 percent of international reserves are held in euros, compared with 68 percent for dollars. But if European firms remain competitive, the preconditions do exist for the euro to reach parity eventually. In the three years since it was introduced on a limited basis in 1999, the euro has come to be used in 35 percent of all international transactions (compared to 45 percent for the dollar). It is being widely circulated in Eastern Europe and in the three EU countries—Britain, Sweden, and Denmark—that have yet to join the euro bloc but are under increasing pressure to do so. Assuming they will eventually join, along with Eastern Europe, the euro's potential strength will lie in the size of its market: In 1999 the GDP of the European Union accounted for 20.3 percent of world output, compared to 21.9 percent for the United States; and its exports accounted for 39.3 percent, compared to 14 percent for the United States. Its population, even before the admission of Eastern Europe, is one-third larger.
If the euro does come to rival the dollar, the euro countries would reap the rewards. They, too, could export their capital around the globe and even run trade deficits without fearing the immediate devaluation of their currency. They could insulate themselves from the effects of American fiscal and monetary policy: If, for example, the United States raised interest rates, they might not have to immediately follow suit in order to defend their currencies. And they could persuade countries that now price their goods in dollars—including the Middle Eastern oil producers—to price them in euros. That would not only eliminate transaction costs, but also allow Europe to establish an independent relationship with OPEC. And these gains for the euro would be losses for the dollar. If the dollar were no longer the universal world currency, the United States would suddenly feel pressure to rein in its foreign debts for fear of suffering a loss in the dollar's value. And as occurred during the Vietnam War—when American military expenditures abroad caused soaring current-account deficits—the United States might have to worry much more about the cost of military operations overseas.
THERE IS, HOWEVER, a silver lining to this potential cloud on the American horizon. If the euro winds up matching the dollar in international importance, it just might foster a more stable international economy, and that would benefit the United States as much as anyone. During the last two centuries, as the eminent economist historian Charles Kindleberger has argued, global economic stability has depended on the existence of an all-powerful currency. The decline of the English pound, for example, was a factor in the onset and persistence of the Great Depression. And since the United States abandoned the gold standard in 1971, the world's economy has slowed and has suffered periodic currency crises—Mexico in 1994, Thailand in 1997, Russia in 1998, and Argentina last year—that have threatened political stability in key regions of the globe. There is little chance that the United States will regain the absolute economic supremacy it enjoyed after World War II—when it exported roughly twice as many goods as it imported, and when not just Latin America, but Western Europe and Japan, desperately sought greenbacks. And if the United States is unlikely to ever again enjoy that kind of economic superiority, it's even less likely that Europe or Japan ever could.
But that doesn't mean the world is condemned to instability. The euro's rise may actually make it easier to create what former Secretary of the Treasury Robert Rubin has called a new “global financial architecture.” If in the past a system of fixed or managed exchange rates required a single dominant currency, but today no currency can do the job, the best alternative may be two dominant currencies rather than a cacophony of competing ones. The euro's rise could essentially narrow the field to it and the dollar, with the yen and the Chinese yuan playing supporting roles. If those four parties cooperated, there's at least a chance the world could return to a fixed exchange-rate regime. In the best-case scenario, a new financial architecture of this kind could rule out the kind of financial crises, precipitated by currency speculation, that have plagued Latin America and Southeast Asia.
The euro's success could also confer one other lasting benefit on the United States and the world. European leaders have always viewed economic integration as a step toward greater democratic political integration—toward what Jean Monnet first called a “United States of Europe.” Political integration (which is slated to include Eastern Europe this decade) could prevent the reemergence of the national rivalries that led to centuries of war, culminating in the world wars of the twentieth century. It would also provide the United States, which has been allied with Western Europe since 1945, with a more powerful democratic partner—one with which Americans would quarrel at times, but which would share an overriding commitment to democracy that, say, China or Russia do not. If a stronger democratic Europe emerges from this avalanche of new bank notes, America's opinion leaders will not only eventually take notice; they may even smile.
This article appeared in the February 11, 2002, issue of the magazine.