Euro Report Card.

Why the new monetary regime has been more successful than you think.

Now that the euro has established a large zone of monetary stability in continental western Europe and its periphery, a hands-off, laissez-faire policy over a wide range of values for the dollar/euro exchange rate is the best near-term strategy. The dollar is no longer needed as the common monetary anchor, as it was in the 1960s. Although disconcerting, the euro's fall from $1.18 in January 1999 to about $0.89 in May 2000 is not out of line with similar fluctuations in the "synthetic euro" weighted by the importance of its constituent currencies from 1980 through mid 2000 (see the chart). The European Central Bank and the U.S. Federal Reserve should intervene only if obvious panic develops, for example, if the euro went from its slow, downward drift to an all-out plunge. Even then, it would be appropriate to nudge the euro back up rather than pegging its dollar exchange rate.

Within Euroland, the new monetary regime has been a great success. Private euro-denominated bond issues are now growing explosively. For the first half of 1999, the table shows overall euro bond issues growing by 80 percent compared with bond issues in the old legacy currencies during the first six months of 1998. Most strikingly, issues of euro-denominated corporate bonds are running at a rate almost four times as high in 1999 compared to 1998. Why the startling difference?

European Bond Issues: 1999 Versus 1998

Volume of euro-denominated international bonds, by issuer type Jan. 1 - Jun. 30, 1999

                                             Total
                        Amount Million $                Issues
Banks/Finance              240,209.117       66.15        597
Corporate                   79,012.498       21.76        166
Utilities                   16,771.171        4.62         33
Sovereign                   16,130.135        4.44         38
Supranational                7,012.887        1.93         31
Others                       4,005.959        1.10         30
Local authority              4,005.959        1.10         30
Total                      363,141.767      100.00        895

Volume of international bonds issued in legacy currencies (includes ecu and euro), by issuer type Jan. 1 - Jun. 30, 1998

                                             Total
                        Amount Million $                Issues
Banks/Finance             131,561.740         65.85      548
Corporate                  28,462.517         14.25       49
Utilities                  20,263.587         10.14       97
Sovereign                  11,595.437          5.80       56
Supranational               6,889.331          3.45       16
Others                      1,023.143          0.51        6
Local authority             1,023.143          0.51        6
Total                     199,779.755        100.00      772

Source: Capital Data, Aldwych House, London, U.K.

When the D-mark was king in the pre-euro regime, corporations in European countries on the German periphery such as Italy, Portugal, and Spain suffered currency risk relative to German issuers of mark-denominated bonds because of the existence of the lire, escudo, and peseta. The resulting risk premia, or higher interest rates particularly at longer term, kept finance short-term and largely bank based. In 1999, the extinction of these risky currencies has allowed previously hobbled Italian, Portuguese, and Spanish (and French?) firms to lengthen the term structure of their debts by issuing euro-denominated bonds at lower interest rates while escaping from the clutches of their bankers. European banks, in turn, are madly consolidating, although only at the national level, unfortunately.

On the demand side, European insurance companies and pension funds had been confined to keeping the bulk of their assets denominated in domestic currency in order to better match their liabilities. But with the move to a common and, in most cases, a stronger currency, they are free to diversify and acquire assets on a Europe wide basis and from foreigners who are willing to sell euro-denominated bonds. Thus, the term structure of corporate finance in Europe is being lengthened with the lower interest rates reflecting lower overall portfolio risk. By eliminating fluctuating currency values to allow broader risk sharing in European capital markets, financial efficiency has been greatly enhanced.

Can the rapid development of a broad and deep capital market in euro denominated assets explain the surprising weakness of the euro since January 1, 1999? Foreign borrowers, say, those from the United States or the developing world, may now be tapping this large, newly integrated pool of euro-denominated capital on a greater scale than had previously been expected. The resulting incipient capital outflow from Euroland has become greater than its (large) current account surplus. But this one-time stock adjustment from the improved conditions in the European financial markets should not persist and is not something to worry about.

On the broader global stage, nevertheless, the dollar's continued vehicle-currency role is unlikely to be displaced by the extended currency-area role for the new euro and the growing net creditor status of Euroland as a whole. Even if the dollar's use as an international vehicle currency outside of Europe is largely unaltered by the euro's advent, eliminating currency risk within the greater European economy is a remarkable achievement.

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RELATED ARTICLE: Will The Real Bob Mundell Please Stand Up?

Does 1999 Nobel Prize in economics winner Robert Mundell deserve the sobriquet of intellectual father of the euro"? Since 1970, he has certainly been an enthusiastic advocate of European monetary unification and seems vindicated by the formal advent of the euro on January 1, 1999.

But Mundell's classic article published in 1961, "The Theory of Optimum Currency Areas" comes down against a common monetary policy and seems to argue in favor of making currency areas smaller rather than larger. Economists arguing against a one-size-fits-all European monetary policy over the last decade have used arguments drawn from Mundell's work! This paradox, where Mundell seems to be on both sides of the debate over European monetary unification, can be resolved by noting that there are two Mundell models, earlier and later.

From his postwar Keynesian perspective, Mundell and most other economists in the 1960s presumed that a flexible exchange rate would be a smoothly adjusting variable for stabilizing the domestic economy. Whatever policy a central bank chose, a flexible exchange rate would depreciate smoothly if the bank pursued easy money, and appreciate smoothly if the bank pursued tight money.

Since the 1971 breakdown of the Bretton Woods system of fixed dollar parities, we have known that insecurely tethered exchange rates can be volatile, disturbing the domestic macro economy more than absorbing shocks. And this volatility is greatly magnified if governments actively pull the levers of monetary and fiscal policy in the old Keynesian mode. Today's exchange rate is largely determined by how markets guess country A's future monetary policy will evolve relative to country B's, a guess that easily and frequently changes so as to cause current exchange fluctuations.

Mundell had already grasped much of this modern perspective by 1970. At a Madrid conference on optimum currency areas that year, he presented two prescient papers on the advantages of common currencies. In one, Mundell showed how having a common currency across countries could mitigate asymmetric shocks by better reserve pooling and more efficient forward contracting. Otherwise, if the exchange rate between the two countries were left flexible and thus uncertain, proper risk pooling in the international capital market against asymmetric shocks would be inhibited.

Mundell's second Madrid paper makes clear his enthusiasm for the great European experiment. As Mundell stated: "The exchange rate should be taken out of both national and international politics within Europe. Rather than moving toward more flexibility in exchange rates within Europe the economic arguments suggest less flexibility and a closer integration of capital markets"

With the formal advent of the euro on January 1, 1999, the forward-looking Mundell of the Madrid papers "triumphed" over his earlier Keynesian incarnation as the originator of the theory of optimum currency areas. But he is intellectual father to both sides of the debate.

-- R. McKinnon

Ronald I. McKinnon is William D. Eberle Professor of International Economics at Stanford University.