European Affairs

A Skeptical Texan Wishes the Swooning Euro Well     Print Email

President and CEO, Federal Reserve Bank of Dallas

Well, they did it. I did not think they would, but they did. Eleven European countries adopted a single currency and a single central bank. And they did so voluntarily and deliberately, without benefit of a crisis. A Texan might say "in cold blood." If monetary union can happen in Europe, perhaps dollarization in Latin America is not so farfetched after all.

My euro-skepticism can be traced to my early study of exchange rate regimes. Back then, flexible exchange rates were seen as insulating against foreign inflations and recessions and as permitting independent monetary policies. It is easier for your exchange rate to adjust to your economy and policies than for your economy and policies to adjust to a predetermined exchange rate.

Real price and wage flexibility is more easily achieved through flexible exchange rates than through flexible nominal prices and wages. Finally, there is the matter of optimal currency areas, inside of which labor and capital are mobile and outside of which they are not. Europe did not seem to fit the profile.

At first, I did not understand why the 11 Euro countries would relinquish their monetary sovereignty just to reduce the hedging and transactions cost of currency conversions. I found it especially puzzling that Germany, with its aversion to inflation and pride in its strong currency and central bank, would lead the way. After all, its macho central bank was called "Buba," albeit spelled differently from a Texas "Bubba" like myself.

It finally dawned on me that monetary union was a political decision, not an economic one. The loss of some sovereignty was not an unfortunate byproduct of the decision - it was the goal. Economic disadvantages were seen as the cost of political benefits. Monetary union was a defensive bear hug. Well, all right then.

The Maastricht treaty successfully imposed monetary and fiscal discipline and achieved convergence in several areas. It gave the central banks political cover for squeezing out inflation. But no good deed goes unpunished. Labor market rigidities raised the cost of disinflation in terms of unemployment, and one could not help but notice that most of the governments that began the romance were not around for the wedding.

But the wedding came off as planned - no one stepped forward to show cause - and the year-long honeymoon was successful, aside from some swooning on the bride's part. Attention now turns to the marriage.

Although the transition to monetary union succeeded in many important respects, the US and British experience during the same period confirmed some of the advantages of exchange rate flexibility. The reduction in inflation was almost as good, while unemployment rates went down rather than up. Unemployment and inflation moved in opposite directions in Europe, while they both declined in the United States and Britain. Granted, this probably had more to do with labor market flexibility than with exchange rate flexibility.

High "structural" unemployment in continental Europe is aggravated by inflexible labor markets, overly generous unemployment and welfare benefits, punitive labor laws, and workers' unwillingness to move where the work is.

Ironically, European workers became the victims of policies designed to protect them and a reluctance to let the labor-market churn work. When companies cannot fire, they do not hire. Less benign policies in the United States and a greater willingness to let the churn work have helped the labor force by encouraging a more dynamic, high-growth economy.

What about the euro's long-term prospects? Will the marriage work now that the honeymoon is over? Certainly, in a narrow sense. When you do not have exchange rates, you do not have exchange rate problems. The United States does not have internal dollar problems. But, from time to time, we do have regional recessions that might have been ameliorated by exchange rate flexibility.

Texas in the late 1980s comes to mind. Would its oil and real estate bust have been as deep and long had Texas had its own currency floating against the US dollar? Probably not, especially if the Dallas Fed were its central bank. The sinking Texas Lone Star would have eased the recession in the 1980s and returned to its rightful position of strength in the 1990s. Just kidding - sort of.

If the euro is to succeed in the more fundamental sense of contributing to European prosperity, it must do so by making supply-side reforms easier - or at least by forcing the issue. Europe needs to reduce marginal income tax rates, deregulate key industries, and, most of all, reform labor markets and safety nets. One might argue that greater labor market flexibility in the United States began with the failure of the air traffic controllers strike in 1981, which ultimately improved the lot of most US workers.

Because the need is so great and so widely recognized, once a credible commitment to reform is made, international investment flows would likely shift dramatically toward Europe and, incidentally, strengthen the swooning euro. Last year's acceleration in merger and acquisition activity is a start, and Germany's recent capital gains tax proposals are encouraging.

Reform could be aided by healthy competition to attract businesses through lower taxes and less regulation. When I visited the European Central Bank in November 1998 - the Eurotower, by the way, looks even less like a central bank than the Dallas Fed - the new German finance minister was advocating limits on tax and regulatory competition to attract businesses.

But the superior performance of Ireland within the Euro 11 suggests that tax and regulatory competition may be just what the doctor ordered. It may be a zero-sum game in the very short term from the European perspective, but over time competition would improve the business climate in all countries.

Was the euro's decline relative to the dollar last year a sign of weakness? No more than the decline of the dollar against the yen during the same period. The participating currencies' appreciation in the run up to EMU probably accounts for some of the weakness thereafter. But the right exchange value for the euro is the same as the right exchange value for the dollar: whatever the market determines within an environment of free trade.

The free trade environment is, of course, under attack around the world, not least in the United States, as demonstrated in Seattle late last year. The case for free trade must be made over and over. There are new challenges in that regard. The United States must resist the temptation to charge dumping with every competitive threat, and Europeans must not let their fear of genetically modified agricultural products become an excuse for protectionism.

I had assumed the fear sprang from protectionist impulses. But ECB Vice President Christian Noyer has persuaded me that much of the concern is genuine and not based on protectionism. We should be guided by science on this and not let fear of the unknown rob us of all the good biotechnology will offer in the new millennium. Are we sure French vineyards have not benefitted over the years from human intervention? Frankly, I do not care.

Back to the question of exchange rate regimes. I am not as pure in my devotion to flexible rates as I once was. I still think they generally are best for large economies with a decent record of monetary stability, whether it be a single-nation economy like the United States or a multinational economy like the Euro 11.

The case is not as strong for smaller economies heavily dependent on foreign trade, especially if they have a history of monetary instability. Argentina, for example, has little choice, given its past. Going off its currency board peg to the dollar would be like a recovering alcoholic going off the wagon. Its only realistic choice is to stay with the currency board or go even further and dollarize.

Mexico is a closer call, but the dollarization option is probably being considered there as well. No doubt, many other countries will be interested in euroizing for similar reasons.

Let me close by saying that we in the United States wish only good things for Europe, the euro, and the ECB. Trade and investment are not like football and war, where there are losers for every winner. Whether the euro assumes some of the dollar's functions worldwide is of no concern as long as it is in the context of free and open trade. I do not think there is a competition, but if there were, it would be like most competition - beneficial to consumers.


This article was published in European Affairs: Volume number I, Issue number II in the Spring of 2000.

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