The euro after three years.
It is therefore appropriate to take stock after these three years and to ask what has become of the project EMU and the euro so far. This should be of interest not only to the Europeans themselves but to economists of all countries, given that the euro zone is not much smaller (in terms of real GDP, population, or geographical area) than the United States and may become even bigger than the U.S. when additional countries (already in the EU or joining it in the next round of EU enlargement) adopt the euro as legal tender. Of course, any evaluation of what has and what has not been achieved with respect to the aspirations originally associated with the advent of the EMU must be very preliminary. This is particularly clear if we recall that some of the main advantages of a common currency, such as reduction of transactions cost and exchange rate uncertainty, are essentially long-run and may have visible effects only after decades instead of years. Nevertheless, even if a comprehensive analysis of the successful and less successful aspects of the creation of the euro has to be postponed, several observations as to whether this process can be regarded as a success or a failure can already be made now.
When it became clear that EMU would become reality, many observers conjectured that the euro will be a strong currency, possibly appreciating against the U.S. dollar and challenging the dollar's hegemony as an international currency [for example, Mundell, 1998; Portes and Rey, 1998]. Neither of these expectations has been fulfilled so far. In particular, the euro has strongly depreciated against the U.S. dollar over the first three years of its existence, as can be seen from Figure 1. This development of the dollar-euro exchange rate came as a big surprise to most economists, and to some extent it remains a puzzle until now.
The picture looks less dramatic if we consider a longer time period, including the depreciation of most European currencies against the dollar in the early 1980s and their subsequent appreciation until 1988. This can be seen by looking at a hypothetical dollar-euro exchange rate over the years since the beginning of the European Monetary System (EMS) in late 1979 (Figure 2). In view of the experiences of the 1980s, the depreciation of the euro by less than one third since January 1999 does not seem completely erratic. Nevertheless, and in spite of the recent reversal of this trend in the dollar-euro exchange rate, the question as to the possible causes of the external weakness of the euro remains.
From elementary economic theory we know that there is no possibility to predict the future development of an asset price (such as an exchange rate), and empirical studies have confirmed this insight by showing that random walk models of exchange rates outperform structural models in terms of forecasting accuracy [Meese and Rogoff, 1983]. However, this does not preclude attempts at explaining (at least partly) the development of the exchange rate of the euro. Several possible reasons for the depreciation of the euro have been proposed as explanations in the economics literature, and each of them contributes a piece to the puzzle without resolving it altogether.
Some authors point towards special circumstances specific to the period of the introduction of the new currency. For example, Sinn and Westermann  stress the role of the pre-euro currencies (especially the D-mark) as parallel currencies in Eastern Europe and Turkey and the importance of D-mark holdings as black money within the countries of the euro-zone (and beyond). Due to holders' uncertainty about the future development of the euro, much of these stocks may have switched to U.S. dollars, pound sterling or Swiss francs (or even national currencies in the case of some Eastern European countries). If this is true, one can expect a considerable appreciation of the euro after the introduction of euro notes and coins. The same can be said if psychological barriers due to the lack of visibility have precluded the euro to enter many people's portfolios before it became available as notes and coins.
A judgment about the performance of the euro becomes more difficult if we get to the fundamentals explanations of the exchange rate. Although several authors [for example, Salvatore, 2000; Neaime and Paschakis, 2002] try to relate the depreciation of the euro to differences in cyclical behavior between Europe and the U.S., and a plausible interpretation in terms of macroeconomic policy differences has been provided [Cohen and Loisel, 2001], De Grauwe  shows that news about fundamentals were more favorable for the euro zone than for the U.S. in 1999 and 2000, hence the link between (observable) fundamentals and the exchange rate of the euro seems to be weak. The formation of expectations in foreign exchange markets may to a considerable extent be driven by speculative instead of rational considerations, and it is notoriously difficult to extract information about expectations from empirical data.
Apart from the possible link between macroeconomic variables and the exchange rate, the former are of interest by themselves when evaluating the performance of the EMU during its infant years. Indeed, one of the goals of monetary integration is the acceleration of adjustment processes in European economies to increase their competitiveness (not the least towards the U.S.). If we look at the key macroeconomic variables that are usually regarded as main policy objectives, we find only limited success for Europe as compared to the United States. Figures 3 to 8 display the development of variables that were used as convergence indicators in the Maastricht process preceding the establishment of the EMU (the rate of inflation, interest rates, the government surplus or deficit, and debt) as well as real-sector variables (real GDP growth, the rate of unemployment) during the 1990s. They show that the euro zone (including the club med countries of Southern Europe known for higher inflation) has outperformed the U.S. i n terms of price stability, but is clearly behind with respect to growth and unemployment and--in spite of relatively restrictive fiscal policies during the convergence process--in budgetary terms.
A look at these figures raises several questions. For example, would a more expansionary monetary policy have resulted in lower interest rates, higher growth and lower unemployment? But what then would have happened to the exchange rate? Is there any link between monetary policies and, more specific, between the monetary regime and goods and labor markets? What kind of policy did the European Central Bank (ECB) actually pursue, and what influences its policy orientation? Could the performance of the euro zone be improved if the pre-ins (the EU members outside of the euro zone) would join? (Note that the EU-15, which includes the pre-ins, does mostly better than the EU-12, the euro zone.) Was fiscal policy too expansionary, preventing a sufficient reduction in government deficits and debt, or was it too restrictive, preventing higher growth and employment? And how should monetary and fiscal policies be conducted in the future?
Analyses and some answers (including tentative policy conclusions) are presented in the papers of this Special Issue of the Atlantic Economic Journal, which were originally presented at various conferences (Conference on European Monetary and Fiscal Policies, Stanford University, June 2001; Allied Social Science Associations, Atlanta. GA, January 2002; International Atlantic Economic Conference, Paris, France, March 2002) and selected after a thorough refereeing process. In particular, Markus Knell, in a theoretical analysis of the effects of a monetary union on labor markets, finds that EMU had no effects on unemployment if its member countries were part of a fixed exchange rate regime before entering EMU (which was certainly the case for countries like the Netherlands and Austria, probably also Belgium-Luxemburg and France, with Germany) and if the monetary policy of the common central bank (the ECB) resembles that of the former anchor bank (the German Bundesbank). If these conditions are not fulfilled (whi ch may be true for other countries of the euro zone), then this neutrality result for a monetary union does not hold.
With respect to the internal decision structure of the ECB, Helge Berger and Jakob de Haan show that the national central banks, and especially those of small countries, have a more than proportional influence in the Governing Council of the ECB. From a political point of view, an arrangement over-representing smaller regions may perhaps be necessary for a central bank in an emerging monetary union to give them a feeling of being involved in the final decisions of the union. From an economic point of view, however, it can create problems because of the considerable economic and political differences in the EMU, which will almost certainly increase with the next EU enlargement, although preferences of national central bankers may change, too, when they participate in the decisions within the ECB.
The question of whether the monetary policy of the ECB should have been less restrictive is treated in the next two papers. Willi Semmler, Alfred Greiner and Wenlang Zhang ask what would have happened to the euro zone economies in the 1990s (during the convergence process) if the (then still national) central banks had followed a monetary policy rule that the authors derive from U.S. data and hence interpret as that of actual U.S. monetary policies at that time. A similar counterfactual analysis is being performed by Fritz Breuss for the ECB policy since 1999. Although these two papers differ considerably with respect to the time period investigated, the model used, and the econometric methodology applied, they arrive at similar conclusions: more expansionary monetary policies (targeting core inflation instead of actual inflation, for example) would have resulted in lower interest rates, higher growth and lower unemployment without additional inflationary risks. These studies provide some support for those cr itics of the ECB who recommend a policy-mix similar to the one in the United States during the 1990s, which resulted in an exceptionally long period of high growth without much inflation in spite of a remarkable budget consolidation.
Fiscal policy is the subject of the paper by Klaus Weyerstrass, which is concerned with the effects of the prescriptions of the EU Stability and Growth Pact (SGP) on Germany, the largest country in the euro zone. In particular, he takes the German Stability Program of December 2001 resulting from the SGP requirements and calculates the effects of policies bringing about a general government balanced budget in 2004 within the framework of a macroeconometric model for Germany. It turns out that composition of government expenditures matters: public consumption and investment should even be increased, along with indirect taxes, at the expense of considerably reduced social security contributions.
Finally, Andrew Hughes Hallett discusses political and economic arguments in favor of and against a possible membership of the United Kingdom in the EMU and finds that those against joining dominate. On most relevant criteria, the UK has fared better than the economies of the euro zone. Hence the EMU countries would gain more by having the UK in than the UK, which might even lose. This result jeopardizes the prospects for a UK membership in the EMU in the near future, although this issue will perhaps be decided primarily by political instead of economic considerations, as was the case with the entire process leading to the establishment of the EMU.
Although the papers collected in this issue of the Atlantic Economic Journal cover only a small part of the vast land of the EMU to be explored by economists, they provide new and unexpected answers to some important questions. If they seem sometimes controversial, they should induce economists to think again about the questions raised and extend or qualify the results such that we will know more about the EMU after another three years.
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Cohen, Daniel; Loisel, Olivier. "Why Was the Euro Weak? Markets and Policies," European Economic Review, 45, 4-6, May 2001, pp. 988-94.
De Grauwe, Paul. "Exchange Rates in Search of Fundamentals: The Case of the Euro-Dollar Rate," International Finance, 3, 3, November 2000, pp. 329-56.
Meese, Richard A.; Rogoff, Kenneth. "Empirical Exchange Rate Models of the Seventies: Do They Fit Out of Sample?," Journal of International Economics, 14, 1-2, February 1983, PP. 3-24.
Mundell, Robert. "What the Euro Means for the Dollar and the International Monetary System," Atlantic Economic Journal, 26, 3, September 1998, pp. 227-37.
Neaime, Simon; Paschakis, John. "The Future of the Dollar-Euro Exchange Rate", North American Journal of Economics and Finance, 13, 2002, pp. 56-71.
Portes, Richard; Rey, Helene. "The Emergence of the Euro as an International Currency," Economic Policy: A European Forum, 26, April 1998, pp. 305-32.
Salvatore, Dominick. "The Euro, the Dollar, and the International Monetary System," Journal of Policy Modeling, 22, 3, May 2000, pp. 407-15.
Sinn, Hans-Werner; Westermann, Frank. "Why Has the Euro Been Falling?," NBER Working Paper, 8352, Cambridge, MA, 2001.
REINHARD NECK *
* University of Klagenfurt--Austria.
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|Publication:||Atlantic Economic Journal|
|Date:||Sep 1, 2002|
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