Benefits and Costs of European Economic and Monetary Union

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Sweden, and Denmark have refused to take part in economic and monetary .... introducing land reform, building infrastructures, building massive industries such ... Unless the program was a complete waste, the north-south disparity would ...
Benefits and Costs of European Economic and Monetary Union

Benefits and Costs of European Economic and Monetary Union GERHARD FINK AND DOMINICK SALVATORE Professor of Business and Economics, University of Vienna Professor of Business and Economics, Fordham University

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ffecting Europe, the United States, and the rest of the world in ways that cannot be entirely anticipated, the creation of a single currency in Europe on January 4, 1999 represents by far the most significant change in the international monetary system since the end of World War II. Never in the past has a group of sovereign nations voluntarily given up their national currency for a common currency; yet eleven of the fifteen members of the European Union (EU) will participate in this new currency, the euro. Only the United Kingdom, Sweden, and Denmark have refused to take part in economic and monetary union (EMU) from its beginning, but in all likelihood they will join by the year 2002. (Because of its inability to satisfy most Maastricht parameters, Greece was not allowed to participate in 1999.) But if and when the United Kingdom, Sweden, and Denmark participate, it would not make sense to exclude only Greece; thus by 2002 all fifteen EU members are likely to adopt the euro as their single currency. In this article, we will first summarize the benefits and then examine the costs likely incurred by the European Union with the creation of the euro. The Benefits of the Euro The general benefits from the establishment of the euro have been amply examined both in Europe and in the United States, and most economists on both sides of the Atlantic generally agree with the analysis and the estimated benefits that are likely to result. They are: (1) the elimination of the need to exchange currencies Summer/Fall 1999 – Volume VI, Issue 2

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Gerhard Fink and Dominick Salvatore between EU members (this has been estimated to save as much as $30 billion per year); (2) the elimination of excessive volatility among EMU currencies (fluctuations will only occur beIt is practically inevitable that a large tween the euro and the dollar, the yen, and the currenand diverse single-currency area, cies of non–EMU nations); such as the European Union, will (3) a more rapid economic face periodic asymmetric shocks that and financial integration among EU members; (4) the will affect various member nations implementation of a more differently and drive economies out expansionary monetary policy by the European Cenof alignment. tral Bank (ECB) than the generally restrictive one practically imposed in the past by the Bundesbank on other EU members (although this has not happened during the first few months of the euro's existence); and (5) a greater economic discipline for countries, such as Italy and Greece, that seemed unwilling or unable to bring “their house in order” without externally imposed conditions. Other benefits of the euro for EU members are: (6) a seignorage from the use of the euro as an international currency (the use of the dollar as an international currency confers about 10–15 billion U.S. dollars in benefits to the United States, and the expectation is that the euro could provide as many seignorage benefits to the European Union); (7) the reduced cost of borrowing in international financial markets (it has been estimated that U.S. cost of borrowing on international financial markets is about twenty-five to fifty basis points lower than it would have been if the dollar were not used as an international currency— for a total savings of about 10–15 billion U.S dollars. Thus the expectation is that the EU could gain similarly from the use of the euro as an international currency); and last but not least, (8) the increased economic and political importance that the European Union will acquire in international affairs. There is, however, concern in the United States that the European Union might use this increased power to become more confrontational in transatlantic relations. To be sure, when there are real and important disagreements it is only proper and fair for the European Union to use its newly acquired clout to protect and foster its economic and political interests. However, the hope is that it will not pursue anti-American policies to simply assert its power. Similarly, the increased economic and political importance of the European Union in international affairs will check american power now that the fear of communism has vanished with the collapse of the Soviet Union as a military superpower. While some Americans may fear the competition that the euro will provide for the U.S. dollar as an international or vehicle currency, this competition will be beneficial, 188

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Benefits and Costs of European Economic and Monetary Union not harmful, to the United States in the long run. It will impose more discipline in the conduct of economic policies in the United States than has been the case since the collapse of the Bretton Woods System. The Major Problem with the Euro The most serious unresolved problem that the establishment of a European Central Bank and the euro may create involves how economic and monetary union member nations will respond to asymmetric demand or supply shocks. It is practically inevitable that a large and diverse single-currency area, such as the European Union, will face periodic asymmetric shocks that will affect various member nations differently and drive economies out of alignment. In such a case, there is little that a nation so adversely affected can do. It is clear that a nation would not be able to change the exchange rate or use monetary policy to overcome its particular problem because of the single currency. Moreover, fiscal discipline will also prevent using this policy to deal with the problem.1 While exchange rate adjustments generally are easy to handle, the only substitute in a monetary union would be direct downward wage adjustment. Since wages are rigid, this instrument has never been used and would meet with strong resistance from trade unions. A single currency works well in the United States because if a region suffers an asymmetric shock, workers move quickly and in great numbers out of the region toward areas of the nation with greater employment opportunities. This “escape hatch” is not generally available in Europe to the same extent. In fact, the Organization for Economic Cooperation and Development and the European Commission found that labor mobility among EU member states is two to three times lower than among U.S. regions.2 The main reasons for lower labor mobility among EU members are language barriers, inflexible housing markets, and the short-time period in which free labor movement has been possible—i.e., since the single market was established. Whether the fifteen member states of the EU are more alike than the fifty U.S. states should not be a question.3 When considering the breakdown by the German “Lander” or the Italian “regione,” regions in the EU may be as different as U.S. states. In addition to much greater regional and occupational labor mobility, there is, in the United States, a great deal of federal fiscal redistribution that favors adversely affected regions. In the European Union, fiscal redistribution has not been of much help thus far because the EU budget is only 1.2 percent of the EU’s GDP, almost half of which is devoted to its Common Agricultural Policy. Furthermore, real wage downward flexibility is greater in the United States than in the European Union. None of these “escape valves” are available to an EU member adversely affected by a negative asymmetric shock. Otherwise, how could we account for the persistence of an unemployment rate of over 10 percent in Ger-

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Gerhard Fink and Dominick Salvatore many and 5 percent in the nearby Netherlands? This difference in unemployment rates among EU member nations is much higher than among U.S. regions. Facing an asymmetric shock, the United Kingdom and Italy opted to leave the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS) in September 1992 and, by allowing their currencies to depreciate, were able to move out of the deep recession in which The move towards the euro they found themselves. However, with single currency this would have been is likely to lead to even aimpossible. For Britain and Italy, regreater concentration of maining in the ERM of the EMS in economic wealth at the EU September 1992 would have involved idly by and watching their core and result in widen- standing unemployment rates increase from aling inequalities with pe- ready very high levels until the recession naturally and gradually came to an ripheral areas. end. No government can afford to do this. In any event, massive speculation against the pound and the lira forced their depreciation. It is true that the establishment of a single currency will prevent such speculative attacks, but this also means that with a single currency the nation will have almost no policy choice available. Rather, it will have to wait out for the recession to cure itself. Supporters of the single currency reply that the requirements for the establishment of a single currency will necessarily increase labor market flexibility and, by promoting greater intra–EU trade, a single currency will also dampen nationally differentiated business cycles. Furthermore, it has been pointed out that highly integrated EU capital markets can make up for low labor market flexibility and provide an adequate automatic response to asymmetric shocks in the European Union. While these automatic responses to asymmetric shocks may in fact be present, they may not be adequate. Meeting the Maastricht parameters will increase labor market flexibility, but this may be a slow process and may not be allowed to take place to a sufficient degree if EU labor insists on retaining many of its present benefits (such as job security and high unemployment pay). Furthermore, “excessive” capital flows may also work perversely by reducing the incentive for fundamental adjustment measures. Pushing up the euro-exchange rate may even produce supply shocks, due to the subsequent increase of individual exchange rates of EMU members adversely affected by an asymmetric shock. A major asymmetric shock would result in unbearable pressure within the Union because of limited labor mobility, grossly inadequate fiscal redistribution, and a European central bank that will probably want to keep monetary conditions tight in order to make the euro as strong as the dollar—all of which are surely the prescription for major problems in the next few years. 190

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Benefits and Costs of European Economic and Monetary Union The Problem of Peripheral Areas The move to the euro is also likely to create serious problems for peripheral EU regions and nations. That is, greater economic and financial integration, which the move toward the euro will entail and encourage, is likely to increase the geographical concentration of economic activities at the core of the EU area and lead to increased economic inequalities between the center and the periphery. Southern Italy, Scotland, Northern Sweden, and even entire peripheral countries, such as Greece, Portugal, and Finland, are likely to become relatively poorer as a result of the process of “cumulative causation.”4 Specifically, peripheral areas and countries are likely to lose their best-trained professionals, who would be attracted to the higher salaries and the better career opportunities in the EU core areas. Similarly, because of the smaller risks and the likelihood of higher returns, the savings of the peripheral areas may flow to and be reinvested in the EU core regions. Finally, it will be difficult for industries in peripheral areas to effectively compete with EU core industries without the natural protection afforded by the previous existence of a national currency. Such progressive relative impoverishment of peripheral areas is evident with many EU member nations, but the process is likely to gain momentum as the European Union moves toward a truly integrated system. The experience with prior economic integration at the national level of many EU member nations clearly points in this direction; additionally EU regional policies to help peripheral areas are not likely to be sufficient to reverse the trend toward greater interregional inequality. For example, after fifty years of a massive effort by the national government to help the Italian south, the real per capita income disparity of the Mezzogiorno is as wide, if not wider today, as it was in 1950. Despite accusations of waste, the Italian government has tried almost everything imaginable to narrow differences between the south and the more industrialized north. It has tried introducing land reform, building infrastructures, building massive industries such as the steel industry at Taranto, creating incentives to small firms, and introducing programs to train labor—all seemingly to no avail. It is wrong, however, to infer from this that the special national effort to help the south has been entirely ineffective. The effectiveness of such a program can only be measured by counterfactual simulation. That is, what would the northsouth difference have been without the massive national effort to help the south? Unless the program was a complete waste, the north-south disparity would have been greater without the government's program to help its poorer region. The point is that the unhampered operation of the market mechanism can be expected to increase peripheral-center inequalities, and even a massive government effort to reverse this trend may not sufficiently prevent regional inequalities from increasing. Despite an even more massive and concentrated effort by Germany to Summer/Fall 1999 – Volume VI, Issue 2

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Gerhard Fink and Dominick Salvatore help the eastern portion of the country restructure its economy after decades of communism, East-West differences remain very large today. Furthermore, peripheral regions can certainly not expect the same degree of effort from the EU Regional Development Fund. This fund is relatively small and with the future entrance into the European Union of the much poorer former communist countries of central and eastern Europe most of these resources will likely flow to them. Thus, the move toward the euro is likely to lead to even greater concentration of economic wealth at the EU core and result in widening inequalities with peripheral areas. Other Problems with the Euro The European Union is likely to face additional problems with the introduction of the euro. The introduction of the euro will enhance competition in the European financial sector among European banks and stock exchanges. Larger banks will prepare for this with mergers and acquisitions within national boundaries. One day, however, national pride will have to give way as truly European banks inevitably emerge. The former safe haven of European banking is already facing significant reductions in employment as the introduction of the euro has eliminated vast fields of banking businesses—for example, all the forex transactions among EMU states—and national mergers become widespread. This trend will intensify when more transnational mergers of banks and stock exchanges arise within EMU.5 Another such problem arises from the conduct of the newly created European Central Bank regarding a union-wide monetary policy. What type of monetary policy will the ECB implement? With Ireland and Spain facing very rapid growth rates and a rise in inflation, while Italy and Germany are facing low growth rates and a high rate of unemployment, Ireland and Spain need a restrictive monetary policy, while Italy and Germany require a lower interest rate. Clearly, the ECB cannot accommodate both set of countries at the same time and is likely to conduct an average monetary policy, which is too relaxed for the first set of countries and too stringent for the second set. It is true that with an ever-more-integrated international financial system the ability of a nation to conduct even a semiautonomous monetary policy is very limited, but with a single currency a nation will not be able to conduct any monetary policy. Another problem that the European Union is likely to face is that various nations are likely to have very different growth rates. Would France accept a growth rate much lower than Germany’s year-in and year-out if that is what will result from a common monetary policy? This is particularly at issue because France would be unable to provide much fiscal stimulus, due to the budget restrictions imposed by the Maastricht parameters, or other strategic help to some industries 192

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Benefits and Costs of European Economic and Monetary Union that it otherwise could if the nation were not part of EMU. Still, during the next few years the EU, especially in France and Italy, must face the strong opposition of organized labor over such matters as the reduction in social benefits, the increase in pensionable age, and the ability of firms to fire workers when justified by economic conditions—all of which is made necessary by the globalization of the world economy. It is true that many of these changes would have to be made anyway, but the euro will accelerate the time framework of the restructuring of EU economies. Politicians will certainly blame market forces for having to introduce these changes. But they will have to answer to an electorate that does not necessarily accept the American model of capitalism, which many European politicians themselves have severely attacked in the past to justify the much higher unemployment rate and lower growth rate in Europe than in the United States. Finally, there is the question of the relationship between both the euro and the dollar and the euro and the currencies of those nations that have decided not to adopt the euro at this time (England, Sweden, and Denmark) in addition to Greece, which has not been allowed to participate because of its inability to fulfill most Maastricht parameters. The exchange rate between the euro and the British pound, the Swedish krona, the Danish krone, and the Greek drachma could be afflicted by the same type of exchange rate crisis that affected the European Monetary System during the first half of the 1990s. A related problem may arise from the large volatility and possible misalignment between both the euro and the dollar and the euro and the yen in the future. With the world breaking up into three major trading blocs—Europe, North America, and Asia—it is likely that interests will turn inward in each block and as a result the relationship between the euro, the dollar, and the yen will be of less concern. This, together with the fact that exchange rates will inevitably have to bear the brunt of the economic adjustment among the major trading blocks, is likely to lead to a great deal of volatility and possibly large misalignments among the major currencies and create serious inter-bloc trade disputes in the future. Conclusions The creation of a European Central Bank and the euro will confer major benefits for the nations of the European Union, but it will also result in significantly greater adjustment costs for EU members affected by asymmetric shocks and exacerbate the economic problems of peripheral EU regions and nations and increase the inequalities with respect to the EU core areas. Other problems are also likely to arise from the type of monetary policy conducted by the ECB, the possibility of different growth rates in the various EU members countries, the relationship between the euro, the dollar, and the yen, on the one hand, and between the euro and the currencies of EU nations that have not currently adopted the

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Gerhard Fink and Dominick Salvatore euro, on the other hand. Despite all these problems, however, it is very likely that the euro will confer major benefits to EU members over time. In the years to come, it is almost certain that the process of economic integration in Europe and globalization around the world will allow the EU to operate much more like the United States in the economic and political sphere. WA Notes 1. See Dominick Salvatore, “The European Monetary System: Crisis and Future,” Open Economies Review (December 1996): 593–615; Dominick Salvatore, “The Unresolved Problem with the EMS and EMU,” American Economic Review (May 1997): 224-226; Dominick Salvatore, “The Operation and Future of the International Monetary System,” in M. Fratianni, D. Salvatore, P. Savona, eds., Ideas for the Future of the International Monetary System (Hingham, Mass.: Kluwer, 1998) 1–45. 2. Organization for Economic Cooperation and Development. Flexibility in the Labor Market (Paris: Organization for Economic Cooperation and Development, 1986); European Commission, “One Market, One Money,” European Economy 44 (Brussels 1990). 3. L. Bini-Smaghi and S. Vori, Rating the EC as an Optimal Currency Area (Rome: Bank of Italy, 1993). 4. G. Myrdal, Rich Lands and Poor (New York: Harper & Row, 1957). 5. G. Fink and P. Haiss, “Finanzplatz Wien,” Bankarchiv (1999): 2.

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