A long term perspective on the Euro

Michael Bordo, Harold James, 4 April 2008

a

A

The European Economic and Monetary Union (EMU) and the euro, the single currency of its members, will be ten years old in 2009. Monetary unions as currency arrangements have been implemented for a few centuries, but the European experiment of embarking on a monetary union without an accompanying full political union is bold and unprecedented. The EMU has precedence in the currency unions of the past (both national and international) but is unique in having a single member bank for all the member states. Historical precedence with fiscal unions is also relevant to the success of the EMU, since the development of fiscal federal arrangements may be of great importance to the successful functioning of the EMU.

The EMU has helped to develop an integrated capital market, as well as providing many obvious consumer benefits in convenience and price transparency for an increasingly mobile European population. Institutions may be conceived of as continually evolving systems of rules whose legitimacy depends on a relatively widely shared consensus that they are not actively dysfunctional. The novelty of a single currency accompanied by divided sovereignty raises a number of problems and potential threats, some of which were anticipated at the time of the institutional preparations for monetary union, while others were not.

Many authors, including Barry Eichengreen (2005) and Menzie Chinn and Jeffrey Frankel (2006), have suggested that, in the light of the continued weakness of the US dollar, the euro will be its successor as the new leading international currency. This sentiment has become more widely shared as a result of the relatively rapid depreciation of the dollar in 2007-8. This means that there is increased sensitivity to the difficulties as well as strength of the governance of the new currency.

The fiscal dilemma

The most obvious threat to the single currency is usually held to arise out of the imperfect control and coordination of national fiscal policies. Some commentators argue as a result that monetary unions produce an inexorable dynamic in the direction of fiscal unions. The stability criteria in the Maastricht Treaty were the subject of immensely protracted and complicated negotiation, and were intended to address this problem. In the aftermath of the recession of 2000-1, and of Europe’s weak growth performance, substantial pressure from the large states led to some loosening of the criteria. When most of the large member states broke the rules, the then-President of the Commission, Romano Prodi, started to refer to the pact as absurd, and a 2005 summit formally modified the rule so as to make it more flexible in the face of cyclical downturns. It has become clear that a formalised system of fiscal federalism would however not necessarily deal with the problems of fiscal indiscipline on the part of member states. On the other hand, some fiscal reforms are needed as in the longer run they might be expected to raise the rate of growth.

Growth rates

The growth rate of the economy will be a central determinant of the likely long run success of the euro. Low growth, or very different rates of growth in different parts of the Euro area, would be likely to raise political questions and produce political tensions around the setting of the common or single monetary policy. Both the ability to comply with the Maastricht criteria and the political tolerance of an autonomous central bank are highly dependent on the overall rate of economic growth. The revival of growth in Europe since 2005 has brought a reduction in the deficits, but they will reappear should there be a renewed faltering. In the longer term (as in other rich industrial countries), the additional costs imposed by increased life expectancy, an ageing demographic structure, and rising health costs are likely to impose a heavy strain. Forecasting long-run developments involves many uncertainties, but almost every contemporary prognosis sees Europe as growing significantly slower than other parts of the world.

There is a political economy reason to worry about the effects of low growth on the euro. In many parts of Europe, globalisation is seen as a major threat to the social order, and these resentments are used by politicians eager to improve their political profile. Workers, especially in manufacturing, are faced with a threat of job losses or radical reductions in income as a consequence of low wage competition from Asia or Eastern Europe. Politically, the backlash against globalisation is associated with the extremes of left and right, which often take their themes and rhetorical engagement from each other. But since the conventional right and the conventional left compete against each other, and need to mobilise as many votes as possible, they are also likely to take up some of the anti-globalisation language in order to maximise their support and prevent a slippage of voters to the extremes. Sometimes they will also experience pressure to transform this rhetoric into policy, and much of the anti-globalisation sentiment may be directed against the euro.

In the 2007 French presidential election, Nicolas Sarkozy derived considerable mileage from criticism of the ECB and then repeated the criticism after the election. The inclusion of the ECB as an institution of the European Union in the slimmed down and revised constitutional treaty raises the possibility that a formal mechanism will evolve for putting pressure on the ECB to make growth as well as price stability an objective of policy.

Regional pressures

Regions with different growth patterns or different political economies are likely to press for different monetary policies, and in a democratic setting the result might be extreme polarisation and conflict. Such polarisation occurred in many gold standard countries in the late nineteenth century, when farming regions believed that they would benefit from the abandonment of a deflationary gold regime and the adoption of a bimetallic standard. In the United States, the agrarian mid-West and the South were pitted against the Northeast; in Germany there was a similar divide between a grain-producing East and the industrial areas of western Germany. Until a general price rise occurred after the discovery of gold in Alaska, Australia and South Africa in the last years of the century, monetary policy was highly politicised. In more extreme settings, federations can even break up.

Financial Stability

In the past, financial sector shocks have played a decisive role in the undermining of monetary regimes and the discrediting of the central banks responsible for their operation. The most dramatic of such episodes occurred in the interwar Great Depression, where banking panics in central Europe and the United States exacerbated the problems of the real economy. Federalism

  • encouraged the development of a banking system that was regional in character.
  • made for inefficiencies in regulating banks.
  • produced a dispute about the appropriate monetary response of the central banking institutions.

All of these problems are likely to be especially acute during the early years of the federation or the central bank.

Europe is an integrated capital market with national bank regulators that respond in different ways to incipient problems. The problem of a bank getting into difficulties because of engagements in a different country is a widely recognised problem, in theoretical discussions. But a unification of banking regulation is still a long way from being realised. The current institutional framework unambiguously limits socially beneficial post-crisis workouts. But it may also limit the capacity to provide efficient preventative or pre-crisis prudential supervision. The consequent limits on the extent to which national regulators were aware of bank problems became highlighted in the credit crunch of the summer of 2007. The ECB supplied general liquidity to the market, and may have been able to avoid some financial distress. But it does not have a responsibility to regulate and thus may not be aware of banking problems until a late stage.

At the same time as finance has become internationalised, each country preserves its own idiosyncratic system of financial supervision and regulation. Though there has been an extensive discussion of the possibility of shifting supervision to the European level, there are practical obstacles to making such a shift (apart from inbuilt bureaucratic resistance from existing regulators). In particular, regulation is often linked to implicit or explicit lender of last resort functions. But such activity has a significant fiscal cost, which at present cannot be assumed at a European level but would remain an issue for national governments and national parliaments.

Conclusions

Low growth will also produce direct challenges to the management of the currency, and a demand for a more politically controlled and for a more expansive monetary policy. Such demands might arise in some parts or regions or countries of the euro area, but not in others. They would lead to a politically highly difficult discussion of monetary governance. This discussion will be more difficult if there is a widespread perception that the international role of the euro is at odds with domestic political demands that the currency should be supportive or sustaining of growth. Financial sector instability, with a potential need for bank bailouts, could also be a source of difficulty. Finally, in addition to all these threats, domestic responses to the challenge of globalisation in markets for goods and services may also be displaced into a discussion of the euro, with the single currency and the central bank that manages it taking the position of fall guy for radicalised and generalised discontent. On the other hand, if all these bumps are overcome and a process of gradual transfer of fiscal responsibility toward greater centralisation occurs, there is the possibility that the euro zone will match the achievement of other late achievers of monetary unification, such as the United States or Germany.

References

Michael Bordo and Harold James, 'A Long Term Perspective on the Euro', NBER WP 13815, February 2008
Menzie Chinn and Jeffrey Frankel, 'Will the Euro Eventually Surpass the Dollar as Leading International Currency?', NBER WP 11510, August 2005
Barry Eichengreen, 'Sterling's Past, Dollar's Future: Historical Perspectives on Reserve Currency Competition', NBER WP 11336, May 2005

Topics: EU institutions, Financial markets, Monetary policy
Tags: EMU, euro, US dollar

Professor of Economics, Rutgers University
Professor of History and International Affairs and the Claude and Lore Kelly Professor of European Studies, Princeton University and CIGI Senior Fellow