Euro: The great experiment

Jonung

By Lars Jonung

On January 1, the exchange rates of the 11 member countries of the European Monetary Union, the EMU, were locked once and for all to the euro, the currency of the EMU. In short, 11 currencies were replaced by one currency. This was rightly hailed as a path-breaking event in the history of Europe.

Presently the euro is greeted with enthusiasm and optimism. However, there are reasons to be more cautious concerning the future of the euro. There are benefits and costs involved with the establishment of the euro, as the case is with any economic reform. The costs or the risks are not obvious for the moment. They will be revealed in the long run.

Let us first look back upon history. It gives us valuable lessons about the workings of monetary unions. It answers questions like: Why were monetary unions created? Why have some monetary unions collapsed? History shows that lasting monetary unions have been created following political unification. The EMU is a different story. Never before in history has a group of independent nations given the power of framing monetary policy to an independent entity like the European Central Bank, the ECB, while still maintaining control over all major aspects of economic policy making, like taxation, government expenditures and fiscal policies.

Great Britain opted to pass on the euro and hold on to the pound sterling, in use since the 13th century.

The EMU is thus a giant full-scale experiment with no clear-cut forerunner. Experience tells us that experiments involve risks as well as rewards. And there are many risks with the EMU. Let us list a few.

First, Europe is not an optimal currency area -- that is, a geographic area well suited to have only one currency. There is no common European business cycle - at least not yet. The Irish economy may be booming while the German economy is in a slump. The absence of a common European cycle creates a major dilemma for the ECB. How should monetary policy be set on a European scale? Should the ECB steer a middle course or decide to help primarily countries in depression rather than in booms? Whichever route is taken, the problem will not be solved.

Second, the members of the EMU will still maintain control over their fiscal policies. And the European fiscal house is not in order. In spite of the stability pact aimed at limiting the size of budget deficits among the member countries, an economic depression within the EMU in the future may cause problems. Such a decline in economic activity would make the budget deficit grow as tax revenues fall and government expenditures rise. If governments feel obliged to restrict the size of budget deficits by tightening their fiscal policies, this will deepen the depression, increasing unemployment. So here a major policy dilemma will arise between domestic goals of full employment and the stability pact of the EMU.

Rising deficits also may become a burning issue when elections take place simultaneously in several EMU member states, as it is tempting for governments during election years to make fiscal policy more expansionary than otherwise. A vast majority of the EMU members will face elections in 2002-2003. Will the ECB have the power to counteract expansionary election policies?

Third, a monetary union requires agreement on the common goal for monetary policy. The goal for the ECB has been defined as price stability -- period. Recently, due to a shift in the political geography of Europe toward the center-left, requests have been made that the EMU should also aim at full employment and growth. It has also been suggested that the exchange rate between the euro and the dollar and/or yen should be pegged. France and Japan have carried out initial talks to that end. The euro may thus be threatened by various demands put on the ECB. A battle over the proper goals of the EMU may take place, undermining the credibility of the new currency.

Fourth, the issue of democratic accountability of the European Central Bank is an open one. Who should control the ECB? This state of affairs will be a source of uncertainty until a solution is found.

By 2003, old currencies in the 11 euroland countries will be considered worthless

Fifth, every nation state has a system of supervision and control of its financial sector, including a lender of last resort, to guarantee the soundness and stability of the financial system. Presently, such a pan-European set of institutions is lacking. It is unclear who will be in charge if a major financial breakdown occurs within the EMU.

This a short list of some commonly acknowledged risks. Of course, they have to be compared with the benefits of the euro. Such rewards may be great: reduced transaction costs for trade within the EMU, price stability within euroland and a move toward a politically and economically unified Europe, in other words a USE -- a United States of Europe.

Only the future will tell us where the balance between the costs and benefits will be -- now that the great euro experiment has started. We should be prepared for some surprises. European monetary history does not end with the euro.

Lars Jonung is a professor of economics at the Stockholm School of Economics. He was chief economic advisor to Carl Bildt, prime minister of Sweden, 1991-94. Jonung has written several books on economic policy making.