CIAO DATE: 11/04

The Euro as an International Currency and its Impact in the Dollar

Dr. Norbert Walter
Chief Economist of Deutsche Bank Group

Occasional Paper Series No. 46

December 4, 2001

European Union Studies Center

If a continent has made up its mind to develop an internal market, then it makes sense that one tries to develop an exchange rate that does not frequently upset all the plans and contracts of the economic agents within this entity by overnight and sudden changes of exchange rates. It was not a businessman or an economist who have created EMU, it was farsighted politicians who prepared ground for that solution. We have to find out whether this Europe is in line with the conditions Bob Mandel indicated as the underpinning of an optimum currency area. The reason for the politicians’ acts was that they believed for good reason that Europe never should be adversarial against each other. It was the political idea to overcome unfriendly action of one country against the other. In economic terms, an attempt to avoid “backing my neighbor policies”. It is quite obvious that one exchange rate is the price of two currencies by definition; and if one partner of the two decides to use the exchange rate as a national policy instrument, it is very obvious that one guy, in order to please his citizens and business circles for example, because of the weak demand devaluating its own currency, by implication appreciates the currency of the other side. And it is very obvious that this is unwelcome, especially if both partners are hit by the same shock . If we were hit by a US recession, both of us would like to devalue, but if Italy devalues DM would appreciate and therefore, it is would be considered an unfriendly act. Than we are in a situation of benign neglect, and we get into a spiral of action of retaliation and again reaction. In that sense, I believe, it was wise to try to overcome adversarial action in between European partners by considering a different exchange rate regime. In the early 70s, it was a very inappropriate time for such effort due to the fact that this time was the time of break-down of Bretton Wood system. We were embarking upon a floating of the exchange rates between the big currencies. At that time a different stability culture in Europe was almost impossible. The period between 1973 and 1977 was a period when exchange rate stability was tried time and again within the European countries but failed bitterly.

These efforts in Europe intensified when Helmut Schmidt took over. He and his state secretary initiated another round of European exchange rate arrangements at the European Summit in 1978. They were the architects of the next round of the European exchange rate mechanism. This mechanism was a kind of peg system with a relatively wide band, and had the intention to move Europe towards a converging path in terms of cost and price developments, and tried to use exchange rates a kind of “corset”. This, however, did not work particularly because France was not yet ready for policy orientation towards the exchange rates. Even this arrangement from 1978 until 1982 did not do the trick. Only after France found out that their devaluation policies did not lead to the expected acceleration of their growth, that they decided to depart from socialism, and pursued policies oriented towards stability. This was the decisive change in Europe. After that the exchange rate mechanism began to work smoothly, and this was the time when we were planning to complete the internal market, i.e. the freedom of movement of goods, services, capital, and labor was established. As of the middle of 1980s there was a clear move towards identifying the conditions for a European Monetary Union.

The stability culture was not only a measure in terms of inflation convergence. Nobody could join the club, if a country didn’t have an inflation rate that is within 1/2 per cent of the three most stable countries. Stability culture should also be measured by the judgment of the financial market. Therefore, the second target in the Maastricht Treaty was that long-term interest rates of candidate countries could not be more than 2 percentage points higher than the three most stable countries. This reflected the perception in the financial market, and was a good idea by itself. Another criteria to join the club was that nobody could join it club has not proven for two years that one could have a stable exchange rate without tension. One must be a member of ERM, and this must not be threatening through speculative attacks for the two years period. Another criteria was fiscal stability which was measured in two terms. Nobody should have more than 3 per cent deficit to GDP as government deficit and no country should have a debt to GDP ration of either above 60 per cent, or not at least close to 60% in the period up to joining the club. These were the two fiscal criteria identified.

I would have been much more in favor of cyclically adjusted fiscal deficit rather than the absolute deficit, for example, and, of course, I advised the government to reconsider it and reformulate it; they rebuffed it. I suggested one should add the share of government in GDP; it should be an important guidepost for the orientation of fiscal policy, and they did not listen. After 10 years of experience, I must admit that those two simple criteria not only have been the most relevant political economical guidepost for European policies but also for worldwide fiscal policies, and, therefore, one must phrase the architects of this. It is one of the best pieces of advice to correct the fiscal policy that was very permissive in Europe.

The introduction of the Euro:

The European Central Bank and regulators and the private sector is capable to manage successfully the logistic problems with this very introduction.

What will the introduction of Euro and introduction of price list in Euro, however, mean?

The ease, with which one can compare the prices across Europe, will increase massively. This is the tome when young generation where they can compare prices via the Internet. Therefore, the competitiveness in Europe will increase a lot. Comparing prices will be quite natural. The result will be downward pressure on a number of prices where we had price differentiation until now. Therefore, we will have a much milder competitive environment as of now, and this is very helpful for the consumer, it will squeeze margins of companies and particularly in some places. By now European is in integrating ever more, and it is very obvious that a number of European countries headquarted in bigger nation states of Europe still have not made up their minds to become truly Europeans. In many sectors, particularly in the services sector, the consolidation in Europe has not yet taken place. If we had consolidation of companies, it was basically consolidation within the nation states rather than across the borders. This has to do with language and regulatory differences, but now these differences became less and less important and it become more and more necessary to do in other sectors what the industry has already done, namely the transnational integration. I do believe that the Euro will be a catalyst for more transnational merges and acquisitions. It is very obvious that if the Europeans would not do it themselves, those who look from outside into Europe will do it for them. Then, basically, American companies would do the Europeanization of our market.

What will happen to the group of countries that we don’t call the “outs” but we call the pre-ins”?

We have learned to use diplomatically correct language in order not to offend people. We call those countries(3) that are not members of the EMU. What will happen to Denmark, the UK, and Sweden? Will they stay outside or will they join? The crucial country is the UK. We are not yet successful in terms of making the UK citizens aware of the economic fact that they are part of Europe. The trade and investment flows show that the most relevant partner to the UK is the EU, not only in terms of level but in terms of the development of the last thirty years. After September 11, Tony Blair not only appeared, he acted, like a statesman. He declared that he would suggest that the UK joins in his second term the EMU, and that he would call for a referendum not later than 2003. I believe he is very serious, and joining the EMU for UK is fully underway. However, I believe it will be a closer call than most people believe, but I consider that 45-55% of probability that the referendum would be rejected. I believe he is a truly European and puts his head on the block. Sweden has the same philosophy of the UK. In their case, it is obvious that they don’t benefit from the flexible exchange rate. The Danish have a completely different philosophy. They fixed their exchange rate towards the Euro with a very narrow band only and they follow the interest rate moves of the European Central Bank. They are not interested in independent policies as the UK or Sweden. Their explanation is very difficult to understand. They stay out, they don’t have the degree of freedom, but the only thing they lose is they cannot support the decision making process of their own interest rate, because they are resisting to become a member of ECB. I cannot understand that. I believe they want to keep their coin as the symbol of their independence.

Another issue of Euro area of extension is the fact that we are in the middle of a process of enlarging the European Union, towards Central and Eastern Europe, it may be the case that by the year 2003 a number of these countries are ready to join. At this juncture, there seems to be a tendency by Western Europe to delay this process but at the end of the day, I guess, by the end of 2004 between eight and ten out of twelve will be ready to join. This would imply the earliest possible joining for Euroland would be in 2006. Because one of the conditions to join Euroland is that a country must be a member of the EU and two years in the European exchange rate mechanism. Therefore, the earliest possible to join formally and legally to the Euroland for these new members would be 2006.

I do not believe in the hypothesis that today’s weak exchange rate of the Euro has to do with the perspective of the so called ‘weaklings’ from Central and Eastern Europe to join the club.

My fear and prediction is that, with the introduction of coins and notes, the time for a correction of exchange rate may have come.