Why the Euro is a long-term bet: the reality is that Europe is undergoing radical change.

The establishment of the European Central Bank (ECB) in June 1998 and entry into stage three of European economic and monetary union (EMU) completed the latest step in a development towards a political union in Europe that has stretched over more than four decades. The introduction of euro banknotes and coins in 2002 will make this process obvious to every member of the general public in the euro area.

Neither the majority of Europeans nor critical outside observers appear to be fully aware of the historical, political and economic dimensions of the euro project. The realization of a single European currency is the most significant monetary event to have taken place since the creation of the Bretton Woods system in 1944. It is, at the same time, the most significant innovation in the monetary history of the European continent. Monetary union is a unique project for which there were no blueprints to fall back on. Given the history and the many different features the countries of Europe have in common, it is a logical step to take. What also has to be borne in mind is the fact that the underlying economic conditions have changed rapidly since the early 1980's, owing to the increasing economic interdependence of the industrial countries and the globalization of competition and markets. There is no doubt that these developments too--along with the radical political changes in Eastern Europe--have been a driving force behind the decision to implement economic and monetary union.

In order to put EMU into perspective for a proper assessment and to make an adequate appraisal of the euro's long-term prospects, it is also necessary to look back at recent economic and monetary history in Europe. Economic and monetary union has already changed Europe and will lead to a further radical transformation. The impact of these changes will only be perceptible over the medium to long term.

The strengthened process of convergence in the early and mid-1990's produced a paradigm shift in economic and fiscal policy:

1. The stability orientation--or stability culture--that applied earlier only to some EU member countries now applies to the entire euro area. This is evident in the essential features which were the precondition for the counter-inflationary success of the D-Mark: price stability as the primary objective, guaranteed by a central bank that is independent of political influence with a policy that is geared to the medium term.

2. The soundness of general government budgets, which is to be ensured by simple, transparent budgetary policy rules likewise geared to the medium term as part of the Stability and Growth Pact.

As part of the convergence process, there was a significant reduction in inflation rates, interest rates, and fiscal deficits, especially in participating countries with traditionally more unstable conditions. The medium-term orientation of policies and the commitment to a rules-based approach both in Eurosystem monetary policy and in the budgetary policies of the member states are a major achievement for Europe. This policy approach is, at the same time, an important precondition for the long-term and sustained success of the euro. The performance of the relevant responsibilities in monetary and budgetary policy and compliance with the established rules lead automatically, as it were, to an optimum policy mix.

In Europe, this paradigm shift in economic and fiscal policy linked to the euro implies an attempted departure from "primitive Keynesianism" and from a destabilizing short-term "stop-and-go" policy in Europe. The aim is to set reliable underlying macroeconomic conditions, to sustainable non-inflationary economic growth and to avoid significant cyclical fluctuations. This policy stance--implemented in a credible manner in the medium term--will result in a strengthening of the economic fundamentals in the euro area and thus also strengthen the single currency.

Not only are these basic developments so far being left aside in broad areas of the public debate: Many critical observers are, in fact, narrowing down experience of EMU to the three years of the ECB's existence. Materially, EMU is being rated as a disappointment of expectations. This is identified in terms of the development of the Euro/U.S. dollar exchange rate or the importance the euro has now achieved as a reserve currency or on the international financial markets.

The fact is that some policymakers in Europe also linked the introduction of the euro to the expectation that the single currency--supported by GPD of a size comparable to that of the United States--could enter into competition with the U.S. dollar as an international investment and reserve currency and become a serious rival within a short space of time. Such hopes were obviously exaggerated.

Exchange rates reflect the markets' assessment of a country's or an economic area's fundamentals. Is the exchange-rate development of the euro--which is the subject of almost non-stop reporting in the media--therefore a confirmation of the failure of European economic and monetary union? The foreign-exchange markets are outstanding examples of efficient markets in which new information is processed immediately and reflected straightaway in price changes. However, perception often focuses on individual indicators, which confirm a specific market sentiment. This cognitive bias leads to asymmetric information, which is consistent with a different pattern of thought and perception that is geared to the very short run. In such a situation assessments are made based on "snapshots" and without a more complex analysis being undertaken. The outcome is that this short-termism combined with herding behaviour leads to a recognition gap.

Even the oft-cited explanation that Europe's lack of economic dynamism when compared with the United States is due to rigid economic and political structures, and to an absence of enthusiasm for reform, only ostensibly provides a deeper analysis of the causes. Such reasoning likewise follows the trend towards short-termism, since it fails to recognize the historical dimension of the single currency and merely repeats the prejudice of a still-sclerotic Europe of the 1970's. What is overlooked is the immense reform the single currency itself represents, the changes that have already taken place in Europe as a location for investment since the process of monetary union was launched, and what follow-on effects this is going to have.

So far, the euro has not gained the importance as an international investment and reserve currency that would have been produced by adding together the weight of the euro-area legacy currencies. In summer 2001, with a share of around 13 percent in total official currency reserves, the single currency attained no more than the level latterly held by the D-Mark, for example. Three years in the history of a currency and of an institution like the ECB are, of course, an extremely short period of time. The habits of central banks change only very slowly when it is a matter of restructuring the foreign reserve assets. The standing of a still-young institution has to be built up. A track record has to be established, giving rise to medium and longer-term confidence, before central banks overcome their restraint in shifting their foreign reserve assets into euros on a large scale. This is also shown by historical experience. For a long time, the pound sterling was the predominant international reserve currency. It was not until after the Second World War that its place was taken by the U.S. dollar as part of the restructuring of the global monetary system. Following that, the D-Mark needed several more decades to become the second-most important investment and reserve currency after the U.S. dollar. The appearance of the euro on the international currency markets represents a "break" in monetary history. Nevertheless, no exaggerated expectations should be directed at the euro, particularly as it is probably the lack of physical distribution that has also been an obstacle to its international use up to now.

The physical availability of the euro will make transparent many developments that have taken place so far in preparation for EMU and during the first three years which, in terms of the general public, have tended to go on "behind the scenes." With the largely-completed European internal market, the administrative and fiscal barriers to free trade in goods and services have become less important. The introduction of the single currency has, moreover, removed exchange-rate-induced planning uncertainties for direct investment and transaction costs in intra-European trade. At the same time, the euro makes it easier to compare prices within Europe. Competition has intensified perceptibly as a result. Owing to enterprises making the necessary adjustments to this changed situation, the euro area is experiencing positive stimuli to growth over the medium term.

On the financial markets, the impact of the single currency is much more tangible, since they respond more quickly to new conditions. Especially in the field of public debt instruments, the euro has given rise to a uniform, comprehensive capital market in Europe. Over the entire maturity range, it achieves a breadth and liquidity comparable with the U.S. markets, from which issuers and investors benefit alike. Looking at the amounts outstanding, the fifteen EU countries were, at the end of 1999, clearly ahead of the United States in this market segment. The integration of the European equity markets has also gathered pace, although it is still being impeded by differences in legal terms on the nationally oriented stock exchanges and by differing settlement systems.

In the longer-term perspective, the euro will require greater flexibility in the economies of the euro area. This has to build on the progress that was achieved to varying degrees in the euro countries during the 1990's. The privatization of state-owned enterprises, the liberalization and deregulation of markets made headway. In that respect, the euro will continue to act as a catalyst in the future. An economy that rejects greater flexibility will suffer the adverse consequences.

The "Europeanization" of the national economies will also bring about an all-embracing competition for economic policies in terms of how they arrange their locational factors, which will be evident in their individual tax and social systems, their labor market conditions, etc. The European economy is still weighed down by a number of unwelcome burdens from the past, such as a high level of structural unemployment, an overstretched welfare state in many countries and the future strains resulting from demographic developments.

In some cases, the introduction of the euro has meant that the structural problems have even become more apparent when compared across Europe. This is because exchange rates and interest rates are no longer available as a "buffer" between the individual economies. However, there cannot be an EU-wide cooperation in the sense of harmonizing "solutions," especially in the case of wages and standards of welfare. Given the sharply diverging levels of labor productivity, a harmonization, say, of labor market regulations would have disastrous consequences for competitiveness and thus for growth and employment in the European economic area. Each country therefore has to target and implement the needed reforms for itself. Globalization forces Europe to be more competitive but not to be uniform.

In a world of free movement in capital and goods, the international standing of a currency is determined not only by market conditions but also by political factors. In the case of the euro, there is an interaction with the politically urgent structural reforms. The euro and globalization are exerting pressure on policies and markets to become more flexible. At the same time, however, the reforms will--in the medium to long term--accelerate the pace of economic growth and enhance the attractiveness of the euro area as well as the single currency. What will be a crucial factor, therefore, is that policymakers commit themselves in a credible manner to tackling the necessary changes and, at the same time, to safeguarding the stability of the euro. As monetary history has repeatedly shown, a stable internal value is the precondition for gaining that sustained confidence of international investors which also gives a currency its external stability.

The European governments have recognized these necessities. At a special meeting of the European Council held in March 2000 in Lisbon, Heads of State or Government adopted a list of measures for preparing the transition to a competitive and dynamic knowledge-based economy. The intention is to remove remaining barriers in the services sector and the accelerated deregulation of what are still public-sector-dominated utilities. Furthermore, the financial services action plan is to be implemented by 2005 in order to give a further boost to the financial markets in terms of their efficiency and integration.

The development and integration of the EU are by no means concluded yet. At present, the Community is facing two major challenges: political union and enlargement by the accession of the countries of central and southeast Europe. The identity-creating impact of the euro means that it has the potential to promote willingness for more far-reaching integration. Monetary union is an irrevocable joint and several community, which demands answers to the question of the future shape of Europe and of its institutions. Monetary policy is already flanked by a joint foreign and security policy and improved cooperation in the domestic and legal policies of the EU. Monetary union is already one part of a political union. In the medium term, however, it requires additional political backup. That is because historical experience again shows that the territory of a political entity and currency areas normally coincide. At this point, the question of the aim of further integration and of a European constitution arises. At all events, the stage of intergovernmental cooperation in foreign and security policy, and in domestic and legal policy should be superseded by truly joint policies in Europe.

For the accession candidates, there opens up the prospect of belonging to one of the largest and most important economic areas in the world and of being able to take an active part in shaping it. For the EU and the accession countries, enlargement will bring with it new opportunities for growth and employment. The geographical area in which the euro is legal tender will be extended in the wake of the enlargement process and the international importance of the euro in 2002 will certainly increase. The physical introduction of the euro could promote its use in central and eastern Europe even at an earlier stage. It may therefore be expected that the D-Mark, which is currently still widely in circulation as a parallel currency in central and eastern Europe, will be at least partly replaced by the euro from 2002.

If one is prepared to judge EMU fairly, looking beyond day-to-day events and the short term, and to incorporate longer-run developments into the appraisal, the inevitable conclusion is that Europe is undergoing a process of radical change.

* A paradigm shift was effected in economic and fiscal policy by the convergence process based on the Maastricht Treaty. In the medium term this is resulting in a strengthening of the economic fundamentals in the euro area and thus also a strengthening of the euro.

* The ECB is pursuing an autonomous strategy tailored to the conditions of the euro area. The ECB has coped well with the difficult start-up phase of monetary union and, on an average of the first three years, has largely achieved its medium-term target of maintaining price stability. Monetary policy in the euro area has been successfully denationalized and depoliticized. This has created confidence and credibility--major preconditions for the acceptance of the euro.

* The euro is a reform program for the economies of Europe. Anyone who rejects adjustments and reforms will be the loser. The necessary structural reforms will accelerate the pace of economic growth and enhance the attractiveness of the euro area and the single currency.

* The euro has the potential to become a symbol for identification with Europe and thus to promote both further European integration and enlargement by the accession of countries in central and eastern Europe.

The Europeans are well on the way to establishing and securing the new European monetary order as a permanent community of stability. If this succeeds, the European economies and the euro will emerge stronger from the process.