Europe after Maastricht.

The problems across Europe in ratifying the Maastricht agreement demonstrate the EC was pushing too hard for monetary union. The delay may benefit the North American economy.

North Americans have some difficulty in following recent monetary developments in Europe with any clear understanding. They find it difficult to see why the move to a single currency at some point in the next 10 years should be at the forefront of European policy-makers' thinking when more immediate issues of recession and unemployment should be grabbing attention. And they are bewildered at the efforts of some European countries to raise interest rates sharply to counter currency pressure even into the teeth of recession that, in some cases, risks turning into outright depression. From a North American perspective, European policy-makers are trying to do too much too quickly for monetary union, while neglecting the more immediate difficulties that face their own economies. The corollary of this view is that, inevitably, the focus of European policy-makers will shift at some point in the relatively near future from one of "competitive disinflation" to one of stimulating growth. In the meantime, the drive to monetary union will be put on the side.

Longer term, however, monetary union is bound to be revived, and, if handled with more flexibility than current efforts, is likely to have significant positive implications for the United States as well as the European economy. By helping to keep European inflation low, any serious drive to monetary union will contribute to low global interest rates. And, by providing a viable alternative to dollars in international portfolios, such a move will strengthen European currencies against the dollar, helping U.S. producers remain competitive.

WHY A SINGLE CURRENCY?

The process of European economic integration snowballed in the second half of the 1980s. The single-market program came at an opportune time when European growth was about to accelerate, and it provided a significant stimulus to investment spending. A mixture of integration euphoria and, later, a desire to restrain Germany within Europe led to a headlong rush to extend the integration of the "real" side of the European economy into the monetary side. This rush was fueled by the stability of the European Monetary System (EMS), the convergence of both long- and short-term interest rates, and the apparent development of an increasingly integrated European capital market. The last was best symbolized by the emergence of the ECU bond market, which an increasingly large number of governments and companies have tapped in recent years.

Few stopped, however, to consider in any detail whether a single currency actually makes sense for Europe--especially the concept of Europe as somewhat artificially defined as the 12 countries that happen to be members of the European Community. Only after the political process to develop a full proposal for monetary union was well underway did the EC Commission produce a detailed study--a study, by the way, that provided extensive details of the benefits of union without much consideration of the disadvantages.

One problem with monetary union is that it tends to generate strong feelings either of support or dissent, most of which are determined by the broader political considerations of whether a more formally united "federal" Europe should be an objective. Certainly, the issuance of currency is bound up inextricably with the issue of sovereignty. But from an economic standpoint, it is far from obvious that a single currency is an appropriate step for the EC to hurry toward.

That is not to say there are no benefits from a single currency. For the EC as a whole, a single currency would undoubtedly make the single-market program work better by increasing price transparency across the whole market. Far more than regulations to standardize product specifications, it would give producers and consumers a genuine sense of working in a common system.

Moreover, it would help overcome two of the key problems--or, to use the recent image of British Prime Minister Major, "fault lines"--that have blighted the European Monetary System, the existing arrangement to link European currencies together. The first of these benefits is that it would allow monetary policy to be set according to the needs of the overall European economy, rather than to suit the objectives of a particular country or region. This is not to say that monetary policy attitudes would necessarily be any easier if they were set by Eurofed than by the Bundesbank. The Eurofed would focus its decisions on pan-European data rather than just German data, just as the Bundesbank focuses its decisions on what is happening in the whole of Germany, rather than just the state of Bavaria. All would feel that they had a say.

The second benefit is that it would address the difficulties in maintaining exchange rate stability in an increasingly integrated European capital marker. The flows that can now develop in response to expected exchange rate moves are so substantial as to swamp official intervention. These problems were highlighted by the recent speculative pressure weakening the French franc against the DM. By just about all objective measures the exchange rate was viewed as appropriate: French inflation is below German inflation; French competitiveness has been improving relative to German; the French current account has moved into surplus and the German into deficit; the German budget deficit is double the French deficit as a share of GDP; and French growth has exceeded German growth over the past year. But the pressures have nonetheless been substantial, causing higher interest rates in France and forcing massive foreign exchange intervention.

THE DRAWBACKS

But against these benefits, it is important to note that there are considerable drawbacks. The most obvious is that the move to a single currency involves giving up an important instrument of policy, an instrument that can be, for example, a very effective means of minimizing the cost of adjusting to adverse shocks. Quite how much latitude nominal exchange rate flexibility gives a country is a little dependent on the country in question. One reason why Americans are biased to floating exchange rates is that the dollar's fluctuations have relatively little impact on the U.S. economy (on both growth and inflation) as the economy is still relatively closed (in the sense that international trade represents a relatively small part of total GDP). In contrast, European economies are more open and thus sensitive to exchange rate volatility.

These differences make for something of a trans-Atlantic perception gap, with Americans viewing exchange rate flexibility as a virtue and Europeans seeing it as something of a curse. In truth, however, there are occasions when an individual economy is hit by such specific problems that, while a flexible exchange rate does not provide all the answers, it does make the task of addressing the problems less painful. Take, for example, the collapse in Soviet trade that plunged the Finnish economy into recession. The subsequent depreciations in the markka have helped provide an offsetting stimulus. More recently, sterling's float down against the DM will help counter the trend to recession that had reemerged in the U.K. economy. Devaluation is not the option that should necessarily be followed all the time. But sometimes it can be a useful device.

Whether or not it is a tool worth retaining is obviously dependent partly on the alternatives available. If the European economy were such a fluid, integrated place that weakness in one country or region sparked a fall in relative wages and a rapid flow of resources (labor out and capital in), then the need for exchange rate flexibility would obviously be diminished. But, despite the impressive moves to integration, this is clearly not the case. In fact, even within countries, there is a startling degree of regional inflexibility. The most startling example of this recently has been in Germany, where wages in the East have been rising to match those in the West, even as Eastern unemployment has mounted. Instead of capital flowing into the region, it is flowing out, and economic weakness is intensifying.

Moreover, Europe does not have a federal fiscal structure that would make up for the failure of exchange rates to adjust. In the United States, for example, the significant role played by the central government in the collection of taxes and pattern of spending means that fiscal policy provides something of a regional automatic stabilizer, raising funds in one strong region and spending them in weaker regions. The lack of a central EC government means that this role is not performed in Europe.

The balance of all of these factors is difficult to judge and, ultimately, very subjective. What is clear, however, is that monetary union is not an obviously correct policy for Europe to adopt. For a particular group of countries, at a particular point in time, the benefits may well outweigh the costs. But, given the irrevocable and far-reaching nature of the changes proposed, monetary union is not something that should have been hurried into on the wave of an integration euphoria. This is a message that financial markets and electorates have delivered loud and clear to European governments so far in 1992.

WHAT NEXT?

Given that Europe may have moved too far too fast on the monetary side, the inevitable question arises of what happens next. If the Maastricht accord had been passed with no dissent, what happens next would have been clearly mapped out: The EC would have moved ahead to Stage II of the process in January 1994 and subjected themselves to a series of convergence tests designed to assess suitability for membership in the union. Indeed, it was the specter of these tests that, in a sense, has been at least partly behind the move against monetary union.

Embedded in the tests was a set of very exacting aims on monetary and fiscal policy. Not only were budget deficits to be brought under strict control, but inflation was to be reduced to low levels, even in countries that typically dramatically exceeded the European average. Into an already sharply slowing European economy, the specter of these deflationary policies weighed too heavily. There comes a point where the long-term virtues of adjustment are swamped by the near-term pain of recession. Many parts of Europe--the U.K., Scandinavia, and southern Europe--have either passed or are close to that point. They already are, or soon will be, reorienting their monetary policies towards stimulating growth and away from the achievement of the arbitrary convergence criteria. That is not to argue that these countries have given up on their objective of restraining inflation. It is just that the inflation battle has been won for a while, and the focus turns to growth.

The same cannot be said for the group of countries still clustering round the DM--which includes the French franc. For them, the attainment of low inflation is likely to remain a key priority in the near-term. But even for this group, as 1993 unfolds, the prospect of disappointing growth and easing inflation points to less restrictive monetary policies. From the perspective of monetary union, the key trend likely to develop, whether policy-makers like it or not, is the notion of a two-track Europe, with the DM-based core holding together. The issue then becomes which countries will follow, and how closely they choose to do so.

In some ways, this would be a very healthy development in the move to monetary integration. As noted above, there are pros and cons in the argument as to whether a single currency makes sense. The balance of arguments tips in favor of monetary union the smaller and more closely integrated the group of countries under discussion becomes. And if that group has already been "self-selected" as demonstrating an ability to hold in against the DM, then that argues that this would be a group that could move quickly--indeed, far more quickly than envisaged even under the draft Maastricht Treaty--to monetary union.

INTERNATIONAL REPERCUSSIONS 

The drive to integration in Europe tends to be very cyclical. In periods of expansion, the drive accelerates. Unfortunately for the proponents of monetary union, it always seems to be elevated to discussion as the European economy turns down (as in 1970, 1978 and 1990). It fades for a little, but then always bounces back.

Any monetary union that eventually emerges will have significant implications both within Europe and outside. From a North American perspective, the main concerns about monetary union have always been the nature of the side-conditions required to make such a union workable. A European monetary union would be harmful to the United States if it were established under such economic pressure that European economies found it necessary to resort, for example, to more protectionism to offset the contractionary effects of forcing a union. Perhaps somewhat optimistically, I assume that these are not the conditions prevailing as the basis for a monetary union. Instead, I assume a monetary union run by a central bank in the style of the European Central Bank of the Maastricht Treaty--a European-wide Bundesbank.

The main impact of such a union would be to establish Europe as a low-inflation zone. Given the significance of Europe within the world economy, this would play an important role in maintaining low inflation in the industrial countries as a whole. From a U.S. perspective, this would provide a very useful additional factor in restraining inflation not just in the current business-cycle downturn, but as a durable phenomenon through the whole of the next cyclical upswing. Low inflation in turn means that U.S. nominal short-term interest rates can remain low, and that long-term interest rates have to drop further.

The U.S. economy would obviously benefit also if the low interest rates-low inflation regime established in Europe led to stronger growth there. As important, however, are implications for the dollar and, for U.S. producers, these are also likely to be relatively benign, as the dollar is likely to remain on the weak side helping maintain the current competitive advantage that U.S. producers enjoy over their European counterparts. The key to this argument is that the emergence of a single strong currency as a potential rival to the dollar in international portfolios would likely lead to selling pressure on the dollar and upward pressure on the European currency. Such a portfolio shift could take a considerable period of time to be fully completed, especially as the fledgling European currency would not immediately attract the capital it might ultimately warrant and, instead, would require a period of time to build credibility.

In some ways, it all sounds too good for American producers--a device that helps maintain low interest rates and a competitive currency. What this underlines is that the American concerns about monetary union are less about the implications of such a system once in place and more about getting there. The worry is that a union will be seen as so overriding an objective that it will force countries to follow such impractical policies that Europe as a block becomes a recessionary, disruptive influence on the world economy. If any good has come of recent currency turbulence, it could be that it has forced the monetary union to be pursued at a more seemly pace and in a more appropriate manner.

The views expressed in this article are the author's and do not necessarily reflect those of JP Morgan.

Mr. Suttle is an international economist at JP Morgan in New York.