by Adam S. Posen, Peterson Institute for International Economics
Entry in the New Palgrave Dictionary of Economics (2d ed., forthcoming)
© Peterson Institute for International Economics, 2007.
The launch of the euro, the European Union’s currency (at least for 12 of the 27 current members), on January 1, 1999, was a birth long foretold. From at least the 1992 Maastricht Treaty onwards, its creation was at the forefront of the European overall integration agenda, and the meeting of criteria for eurozone entry dominated macroeconomic policymaking in Western Europe. The academic and policy discussion of European Monetary Unification’s (EMU) potential advantages and disadvantages began even earlier.1 New international reserve currencies, as the euro has begun to be, do not come along every day, or even every century. New currencies in general are launched usually out of need, due to replacement of a currency of hyperinflation eroded value or to political fragmentation or secession; when currency unions are formed, they are usually done as pegs to a previously existing anchor currency of the largest and/or most stable member economy. The euro’s voluntary adoption by sovereign but not politically unified nations, and its replacement of already stable currencies (notably the Deutschemark), is thus an extraordinary monetary experiment and policy undertaking.
While the euro certainly has had no shortage of champions among economists—including beyond Euroland’s borders the economists Bergsten (1997), Eichengreen (1998), Mundell (1998), and Portes and Alogoskoufis (1991)—the tendency for many monetary economists observing the euro has been to be skeptical: first of the virtues of the goal of monetary integration in Europe itself, then of the project’s political viability, and then of its economic sustainability, in a turn asserting that the euro was a solely political project.2 Only recently, as the euro passed its eighth birthday in wide usage, remained well past parity with the US dollar (see figure 1 left axis for history of the dollar-euro exchange rate), and experienced a strong cyclical recovery in the eurozone, has sentiment changed. Increasingly, the question is being raised whether the euro might appreciate against the dollar for an extended period, be the beneficiary of substantial international portfolio adjustments, or even begin to supplant the dollar as the dominant global reserve currency.3 The euro’s viability in its own large economic area may not be sufficient to set it on a path to monetary leadership, but its existence now presents an alternative for capital markets to turn to should the dollar’s own attractiveness diminish.
Figure 1 Dollar-euro exchange rate and real GDP growth differential, 1999-2006
Source: IMF, IFS Statistics
The waiting for US missteps for the euro to rise in importance, however, is a critical commentary on the limitations of the euro’s importance to the eurozone member economies’ economic performance in and of itself. When the euro was first proposed, a number of studies claimed that there would be significant direct benefits from monetary integration to the economic performance of member states. Emerson et al. (1992) estimated that the elimination of transaction costs from moving to a single European currency would yield direct benefits of up to 0.4 percent of EU GDP; European Commission (1996) later estimated cost savings of 1 percent of GDP simply from eliminating transaction costs. European Commission (1990) made the case that the reduction of nominal and real exchange rate uncertainty would lead to significant growth in intra-EU trade and investment. Financial markets in particular were expected to benefit from the introduction of the euro—McCauley and White (1997) and European Commission (1997) forecast a rapid deepening and liquidity increase in European bond and lending markets, and perhaps even a “decoupling” of European interest rates from those of the United States.
While empirical investigations to date of these effects remain mixed in interpretation, there is no question that the real economic effects of the euro’s launch on the eurozone member countries have been something of a disappointment. In particular, European financial markets and trade integration are far deeper today than they were before the adoption of the euro, yet how much this represents the effect of the euro on EU integration versus the broader international trends in the direction of globalization that benefited noneuro members as well is in doubt.4 The eurozone’s interest rates remain asymmetrically affected by US interest rates, at least until recent times, as established by Chinn and Frankel (2003). The effect of the euro on price convergence and on macroeconomic discipline cannot be all that substantial, if on net there has been limited visible improvement in either of these areas.5 It seems that the euro has proven on net ‘irrelevant’ to real growth performance of large continental European economies, neither a harm nor a boon to them, as Posen (1998) forecast it would be.
External Opportunities and Shortfalls for the Euro
The degree to which the euro comes into wider usage beyond intra-eurozone transactions—e.g., as an invoicing currency in world trade, is a major issue because of the eurozone’s already large share of world output and trade (roughly comparable to that of the United States) and of the ability to take for granted the “domestic” monetary stability of the eurozone. Size does matter for international currency purposes. Yet, insufficient integration and depth of European financial markets as well as lagging economic performance remain constraints on the euro’s wider adoption and usage. Also important is the lack of coherent institutional representation for the eurozone in international monetary forums. Compared with the European Union’s one voice in global trade negotiations, the inability of the eurozone to speak as one entity is rather striking, especially given the unconsolidated over representation of the eurozone at the Bretton Woods institutions.
History also plays a role, however, in the global demand for currencies and their strength. Inertia and incumbency clearly contributed to the lingering of the British pound in a significant share of international reserves well after the Second World War. Yet, the combination of macroeconomic mismanagement and growth underperformance in the United Kingdom from the 1920s through the 1980s eroded that role, and it is worth remembering that the passing of international monetary leadership from the pound to the dollar in the mid-20th century was in large part driven by these factors undermining the pound’s reserve status. The current accumulation of international debt by the United States could contribute to a similar switch now that the euro is available. An extended dollar depreciation, the natural reaction to a multiyear series of widening US current account deficits, could induce a persistent portfolio diversification into euros by private and official holders of dollars.
In Washington, Frankfurt, and Brussels, however, the widespread governmental opinion remains that the euro will not close the gap in usage with the dollar until the eurozone closes the gap with the US economy in per capita GDP growth and employment on a sustained basis (figure 1 right axis shows the growth differential of the United States over the eurozone). In a typical official expression of this sentiment, Quarles (2005) finds that “too much attention is being focused on exchange rate[s]…and too little on what seems…of far greater importance: namely, the more effective functioning of economies” with regards to growth in output and employment. Successive US governments have viewed both the short-term international adjustment process and the longer-term role of the euro vis-à-vis the dollar as driven by the gap in growth rates between the United States and Europe—with the burden on European economies to catch up by raising their growth rates. EU officials’ disappointment with the degree of structural reforms catalyzed by the euro’s introduction echoes this view, as does the promotion of the Lisbon Agenda for promotion of growth in the European Union.
Such an external relative focus does overlook one achievement of the euro’s launch: ending the succession of devaluations, competitive depreciations, and currency crises that had beset the members of the Exchange Rate Mechanism (ERM) prior to 1999. Certainly, the experiences of intra-European depreciations upon countries exiting the ERM, especially those of 1992–93, and their impact on economic performance and political outcomes in member states were in the forefront of European policymakers’ minds when the run-up to the euro was underway in the late 1990s. And, despite the divergence in past histories of some eurozone members, inflation and inflation expectations have remained stable and low in the eurozone. That could have been expected to assist in trade promotion among the already interdependent Eurozone member economies (see the Rose entry on Currency Unions in this Dictionary).
Still there has been little or no expansion in trade due to the euro’s adoption—among other evidence, the share of total euro-area exports destined for other members of the eurozone did not increase with introduction of the currency, as would be likely if the common currency promoted trade.6 As shown in Rogers (2003), the bulk of convergence in traded-goods prices within Euroland occurred between 1990 and 1994, in response to the creation of the single market, and not after 1999 and the introduction of the euro. Turning to the global dimension, there has been little change in the share of foreign exchange transactions denominated in euros globally from that previously denominated in deutsche marks. Similarly, the use of the euro as an invoicing currency is somewhat higher than that for the eurozone home currencies prior to EMU, but remains far from universal within Europe or even comparable to the dollar’s usage (with the regional exception of some of the newest members of the European Union).
Even the spreading use of the euro in the European Union’s new members in the east has been far less than many might have expected. A critical part of this outcome has been the European Central Bank’s (ECB) insistence that all prospective eurozone members go through the full Maastricht Treaty specified process for qualification, including not just fiscal discipline and nominal convergence, but also a two-year period in the “waiting room” of a new ERM-II mechanism. Early, expedited, or unilateral adoption of the euro in EU member countries has in fact been discouraged by the ECB (with the exception of Estonia’s pre-existing currency board with the euro). Arguably, this has as much to do with the ECB’s desire for perceived control over monetary developments, given the ECB’s Bundesbank-esque “Two Pillar” strategy, and for keeping decision making in the European System of Central Banks (ESCB) manageable, as with maintaining necessary discipline on eurozone members (see the entry by Binder and Vieland on the ECB in this Dictionary). The ECB has also been explicitly opposed to “euroization” (dollarization with euros) by non-EU member countries, again partly for monetary control reasons, albeit acknowledging its contribution to stability in the postconflict Balkan economies.
Limited Impact of the Euro on the Eurozone Financial Integration and Performance
The euro has delivered monetary stability in the face of a long list of economic shocks, and a large initial decline against the dollar, only to rebound strongly in recent years (see figure 1). Europe has failed to follow up the creation of the euro with the complementary policy reforms that were widely expected, however. This leaves an underlying tension between the constraints on national economic policy measures (such as those in the Stability and Growth Pact on fiscal policy, discussed in Wyplosz’s entry on EMU) and the national frustrations with poor economic performance—a tension that raises recurrent doubts in euroskeptic financial markets about the sustainability of the euro itself, despite its lack of obvious vulnerabilities or viable exit options for any member country.
The euro was widely expected to transform two aspects of the eurozone economies: the integration and depth of their financial markets; and the conduct of their macroeconomic policies. Particularly with regard to the former, there has been beneficial change at least partly attributable to the euro’s introduction and acceptance. Money market integration, which is critical to the implementation of a single monetary policy for the eurozone, given the need to transmit monetary policy in a decentralized fashion across the member economies, has succeeded. It took European money markets less than a month in 1999 to “learn” how the new operational framework functioned, and to eliminate most of the volatility and cross-border dispersion in overnight interest rates. The evidence of integration in the unsecured lending rates in the European money market is similarly clear. Rey (2005) finds that government bond markets have seen intra-eurozone interest rate spreads virtually disappear, and benchmark securities of different countries have begun to emerge. Corporate bond markets went from “almost nonexistent” prior to EMU to 150 billion euro of issuance in 2003, and the euro swap market has become the largest financial market in the world.
Eurozone financial markets, however, still have a long way to go to become a global competitor with those based in London or New York. Factors in the nonfinancial economy, such as legal differences, obstacles to more rapid real growth, transaction costs, and institutional gaps in financial supervision combine to keep the eurozone from achieving truly deep, integrated, financial markets, despite the removal of currency risk. Thus, there remains a striking contrast between the repo and unsecured market in degree of crossnational differences in interest rates due to the ongoing lack of harmonization in legal and procedural treatment of financial instruments in the eurozone countries. There also are still costs in the eurozone to making cross-border securities transfers that are more than tenfold what they are within countries.
Given the recent surge in capital flows across borders worldwide, almost half of which were in the form of portfolio investment, one would expect greater influence of market opinion about assets in a given currency or region upon the actual allocation of capital between regions. It seems that prospects for economic growth drive the relative demand for a region’s assets, mostly by determining where trade and investment expands, which then in turn sets the pace of stock market integration of that region with the rest of the world. Given the medium-term outlook for European growth, this appears to militate against an increase in investment and therefore in integration (and influence) of European capital markets, which might be partially offset by some diversification incentives. In the long run, though, a slow growth rate in Europe would also translate into a smaller share of global GDP, and less incentive for central banks to hold euro-denominated reserves. In this context, Forbes (2005) and Lane and W ä lti independently investigate whether the euro’s launch prompted greater comovement of stock prices within the eurozone across national borders, indicating greater financial integration as a result of EMU. Both investigations find that stock market correlations of eurozone member markets with the United States increased by more after the introduction of the euro than the increase between the eurozone countries.
Future Prospects for the Euro
The euro therefore enters is in something of a halfway house. On the purely technical functions as a currency, it has been a resounding success, with no problems in acceptance at home or abroad, or in the payments system, as well as displaying convergence in key eurozone money market interest rates. There has also been evidence indicative of stable low inflation expectations for the varied eurozone membership as a whole, and that remains an outstanding achievement of European central banking. None of the broader forecasts of economic doom or internal political conflict predicted by (mostly American) Cassandras came to pass, and those predictions look less credible than they ever did. European financial markets have significantly deepened and added liquidity since the euro’s advent, particularly for fixed-income securities. The sheer size of the eurozone economy as well as the ongoing adjustment of the world economy to US current account deficits do propel the euro towards a prominent global role.
At the same time, however, European relative economic performance and growth potential will continue to fall short of that of many other advanced economies and large emerging markets for the foreseeable future. The euro’s adoption and the associated convergence process have failed to induce, let alone produce, the needed transformation in European economic structures, policies, and performance. In most scenarios, a collapse in the dollar in the coming years, or even an ongoing orderly adjustment involving higher US long-term interest rates and lower net imports, will have at least as great a contractionary effect on the eurozone as it will on the US economy—even if the Asian currencies take on their share of the adjustment burden. And if the Asian currencies, notably the Chinese yuan and Japanese yen do play their part, reserve switches accruing to euro denominated securities, and their political benefits, will diminish along with the euro’s share in the adjustment process. And as yet there has been little evidence of a change in global invoicing patterns from dollars to euros for traded good transactions.
In short, the euro has been a success within limits at home, but the eurozone economy remains sufficiently weak that on its own merits the euro would be unlikely as yet or even for some time to challenge the dollar as a global reserve currency or even to be widely utilized outside of its borders. The euro, however, is not judged solely on its own merits, either by markets or by the international community, but rather is judged also in relative terms against developments in the dollar zone and elsewhere.
1. See Canzoneri et al. (1992), De Cecco and Giovannini (1989), De Grauwe (2000), and the references therein, as well as the seminal European Commission (1990) and the Cecchini Report (1988). Most of these studies concerned how best to make EMU work, taking the goal as a given, or assessing the optimality of the European Union as a currency area. See also the entries on European Monetary Union (Wyplosz) and on Currency Unions (Rose) in this Dictionary.
2. Notable examples of this skepticism include on the political side Currie et al. (1992), Walters (1990), de la Dehesa (1995), and famously, Feldstein (1997), and on the economic side Arestis and Sawyer (2001), De Grauwe (1996), Dornbusch (1989), Giavazzi and Spaventa (1990), and Weber (1991). See also the recent essays by euroskeptics in the face of mounting contrary evidence collected in Cato (2004).
3. Recent examples include Chinn and Frankel (2004), Obstfeld and Rogoff (2004), and Summers (2004).
4. See Forbes (2005), Lane and Wälti (2006), Mann and Meade (2002), and Rey (2005).
5. See the assessments of price convergence in Bradford and Lawrence (2003) and Rogers (2004) and of macroeconomic discipline in Posen (2005b).
6. Baldwin (2005) provides an excellent analytical summary of the evidence on this score.
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Currie, David, Paul Levine, and Joseph Pearlman. 1992. European Monetary Union or Hard EMS? European Economic Review 36, no. 6: 1185–204.
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