The Single Currency: A Debate that May Not Happen

01 June 1997

After five years of an apparent consensus among the major political parties about European Monetary Union (EMU) and a single currency, the immediate future of the Maastricht project has emerged as the defining issue in the European election cycle: first in Great Britain, now in France, and next year in Germany. Will there be a serious debate? Perhaps, but the opportunity may be fumbled by an opposition that fears being tarred with the brush of right wing nationalism, Euro-skepticism, and anti-modernism. The single currency and EMU has become the third rail of European politics; no mainstream political party wants to touch it. With this possibility in mind let me put the economic case for a postponement of the single currency's inauguration.

Economic conditions are vastly different today on the eve of a single currency than they were between 1989 and 1991 when it was conceived at Maastricht. Unemployment is as much as fifty percent higher, budgets are stretched to the limit as governments face deficits enlarged by the deep recession, and interest rates until recently have been too high for this stage of the economic cycle. The cost of German unification is the proximate cause of the recession, and they far exceeded estimates at the time of Maastricht. Economic recovery in Germany - particularly in eastern Germany - is stuck. The latest phase of globalization has weakened a Europe that remains structurally unable to keep up with the moving target of competitive challenges from outside the continent.

EMU is touted as Europe's answer to all of these problems. But is it? To compete with the United States, Japan, and the newly-industrializing-countries of Asia, according to this argument, European companies have to become larger. No one nation in the EU is large enough to produce larger companies. The single currency, therefore, will allow Europe to achieve the right scale of production by lowering transaction costs now associated with currency conversions.

Lower transaction costs will stimulate more cross-border mergers and acquisitions, create a larger internal market, and allow European companies to become more price competitive.

Every argument turns on transaction costs and currency conversion. If transaction costs are the impediment, however, a single currency is a very costly and ineffective policy answer. They can be lowered directly by a more efficient clearing mechanism among banks at lower cost than by monetary union. Modern marvels of information processing, computer power, and telecommunication wizardry are ideally designed to tackle this problem. In these areas Europe is woefully behind best practice financial institutions and will have to make the investment and internal changes in banking practices even if there is a single currency. Nothing will magically transform old practices and obsolete technology.

Currency conversion costs do not presently inhibit Europe's multinational competitors from globalizing production, dealing in multiple currencies on every continent of the globe, and coming out with a price competitive product.

To build a commercial aircraft, to take just one example, Boeing juggles currencies among contractors in several dozen countries. They can do this through financial markets that have innovated in futures contracts, hedging arrangements, and derivatives. All of these are available to European companies.The European Commission's estimates of transaction costs for currency conversion in the EU are less than one-half of one percent of turnover, only one-tenth-of-one percent for the larger members, and one percent for the less-industrialized states in the EU. These could be reduced further.

So why does the specter of transaction costs produce such support for the single currency? The answer is found in the image conjured up by transaction costs that everyone has experienced traveling through Europe: waiting in line at a bureau de change, replacing one currency with another, and walking away with much less than the spot rate for foreign exchange. Indeed, this is the visual image flashed across television screens whenever the single currency is discussed.

But it is a false image and has nothing to do with the reality of transaction costs that banks and companies face.

If the goal is lower transaction costs, EMU is the equivalent of using a sledge hammer to hang a picture on a wall. Estimates of the direct cost of conversion to the EURO range from Brussels's ten billion dollars to EuroCommerce's estimate of 33.5 billion dollars, or enough to build two Channel tunnels. And even after this effort, most of Europe's competitive problems will remain. National champions will continue to find favor among states in the EU, and the longer the recession the greater will be the pressure for protecting national producers. Production scale will remain an illusory objective after the single currency as it is now.

The devil is in the details of monetary union. Political leaders and opinion elites seem to treat the single currency as an act of instantaneous deliverance, almost a mystical religious experience in which everyone in the EU will undergo a conversion and one epoch will fade out and another one fade in. Such millenniumism can only lead to dashed hopes.

If the single currency project is not designed to deal with Europe's fundamental economic problems and its timing is ill-suited to current economic conditions, how can the recession in Europe and the apparent lack of international competitiveness be explained? Economic problems in Europe are largely post-1991 and not of a long-standing character. They are an after-shock from German unification, made worse by Maastricht. The second half of the 1980s saw an EU emerging as a stiff rival for the United States and Japan in both economic performance and in its unique model of the social market. As an alternative to America's reliance on excessive individualism and Japan's on excessive conformity, it offered a third way toward the reconciliation of individual and public interests.

Western Germany's leveraged buy out of eastern Germany, with heavy borrowing instead of taxation, changed the economic landscape in the 1990s. Interest rates soared, the Deutsche mark became overvalued, and recession struck not just Germany but other countries in the EU that were locked into synchronized policies mandated by Maastricht but not suitable for their countries' economies. There was no reason, except for the EMU project, for France to raise interest rates, drive the franc to over-valuation, and induce unemployment when its economy faced little inflation and reasonable budget deficits.

Policies required for the German economy were imposed on France in the name of Maastricht, though camouflaged by the soothing sounds of a franc fort strategy, when they were neither needed nor useful for the circumstances of the French economy. It is precisely such synchronized swimming that has radically distorted EU economies and made them less competitive.

On top of Germany's unification shock, Maastricht added economic austerity in the form of the deficit target just when economic stimulus was called for. Outside of Germany inflation was not a problem but rising unemployment was in the early 1990s. Prudent economic policy called for lower interest rates, currency adjustments, and fiscal encouragement in those other EU countries. Instead the Maastricht criteria imposed a policy mix of the wrong sort not seen since the Great Depression: high interest rates, over-valued currencies, and fiscal austerity in the midst of serious unemployment and low inflation. These policies were necessary for Germany in light of how they financed unification but not for the other EU countries. The only break has come from slightly lower interest rates and some currency adjustment over the past nine months. Lower interest rates, however, take anywhere from eighteen months to two years for their impact to be felt, and this is precisely the moment when the phasing in of the single currency will require higher interest rates to stabilize the value and assure financial markets of the solidity of the new EURO.

European economies need time to revive before a single currency becomes feasible, especially under current criteria that worsen prospects for revival. The criteria themselves are curious. Lost in the obsession with the three percent budget deficit number is the fact that Maastricht required others for interest rates, inflation, and national debt. The last one has been dropped even though the planners knew that would be the one that really disciplined economic managers. Nowhere in this cluster is unemployment. All of the convergence criteria are financial. However, there has never been an explanation for why unemployment was not a criteria for monetary union when economic theory would dictate its inclusion.

A politician's opposition speech, therefore, goes as follows: The single currency was designed for economic conditions that are not met in the EU today. Unemployment was neglected as an economic convergence criteria when economic wisdom requires its inclusion. The single currency is such an important step for Europe that it must be done right the first time. More than a bare majority of the public should support it. Problems, such as currency conversion costs, can be directly addressed at lower cost and less social disruption.

We should revisit the criteria at the June Amsterdam summit and agree to add the standard that unemployment rates be those of 1989-1991 when the single currency project was conceived. We have effectively revised Maastricht by not adhering to all of the standards agreed to in 1991. So formally reconsidering Maastricht, instead of fudging principles that are no longer convenient, should build confidence in the process not weaken it. With the addition of unemployment as a fifth standard, the introduction of the single currency should be postponed until all of the revised Maastricht criteria are met.