Sunday, January 26, 2003

Euro: What to Do Now?

Brad de Long scratches his head and asks: what to do now:

The Euro: One Size Fits None

Marty Feldstein, back before the start of the euro, was greatly worried that a single currency would result in too much business-cycle volatility across Europe: countries would not be able to use either fiscal or monetary policies to stabilize their domestic economies because both would be fit to a common European pattern. In Business Week this week, some evidence that his fears were well-founded. Of course, that doesn't tell us what to do now...
Source Brad de Long's Semi-Daily Journal

BW Online | January 24, 2003 | The Euro: One Size Fits None: Too much political capital is at stake -- especially in Germany and France, the euro zone's key economies -- for the euro ever to crumble. But as Germany's economy slumps into its second year of recession, the difficulties of designing a single monetary policy for 12 different countries are increasingly evident. That's worrying many of the senior businessfolk gathered in Davos, Switzerland, for this year's World Economic Forum. "The euro zone's monetary policy isn't a case of one size fitting all but of one size fitting none," says the chief financial officer of one Spanish company. "The result is that Germany is having to cope with higher interest rates than it needs, and its economy is slowing as a result. And that's affecting everyone across Europe."

SPENDING LIMITS. The problem is the Maastricht Treaty mandates that the European Central Bank maintain price stability across the entire euro zone. It can't take conditions only in Germany into account when setting rates, even though Germany is the Continent's largest economy and is a drag on growth in other countries. The ECB's key interest rate stands at 2.75%, whereas economists say Germany really needs a rate as low as 1% to stimulate demand, investment, and growth. Fiscal policymakers in Berlin are powerless to kick-start the sputtering economy because the Stability & Growth Pact puts tight limits on state spending. In particular, they may not run a budget deficit above 3% of gross domestic product. Germany's euro-zone partners have just censured it because it breached the 3% limit last year and will probably do so again this year.

Some eminent economists, such as Robert A. Mundell, professor of economics at the School of International & Public Affairs at Columbia University, argue that the Stability Pact should be scrapped and that the ECB should be given a broader mandate. Yet many European business executives take the opposite line. Gerard J. Kleisterlee, president and chief executive officer of Dutch manufacturing giant Royal Philips Electronics, says the single currency needs to be underpinned with sound state finances. Ironically, German government officials agree. Caio Koch-Weser, Germany's Secretary of State of Finance, says it would be a mistake to abolish the pact.
Source: Business Week On Line

What to do now is an extremely moot point. I don't suppose there's much mileage in repeating the old British expression: always look before you leap.I suppose the best we can do is watch and wait since it will be some time before any of the responsible parties are likely to be prepared to admit to a mistake and start to undo the dammage. Meantime various possible scenarios do of course suggest themselves

On the one hand the inflation riddled southern fringe (Spain, Greece, Portugal) may find themselves launched into an Argentina-style rapid exit mode as rapidly rising costs make it increasingly difficult to create new jobs. On the other the German voters who are being asked time and again to foot the bill for what is at heart an unworkable system, may themsleves get so fed up that they decide they want the mark back and leave.

Either way things are still going to have to get a lot worse before anyone bites the bullet on decisions. However recent events on the Iraq front may ironically have given matters a hefty push. I don't know if anyone else is following this, or it's just me, but I can't help noticing that each time an Iraq hawk makes a strong speech the dollar drifts down a few points. Meanwhile the US treasury stays strangely silent. Reading Ben Bernanke carefully, it's clear that a weak dollar is a good hedge against perceived deflation dangers, so letting it drop without openly changing policy seems like a good move. A kind of knock-on Iraq effect. Meantime up and up goes the Euro. Since one common candidate on everyone's shortlist of potential 'Japans' is in fact Germany this could be just the shock they need (this and the firm fiscal tightening coming from the stability pact) to get them well and truly going. In which case, ZIRP will be well and truly on the order of the day, and then.......

It is interesting to note that Euro membership is not synonymous with EU membership, as with the 10 new entrants a majority of EU members (13-12) will not be in the Euro. The following link from Morgan Stanley's Global Forum might be of interest since it shows that the 4 key new Eastern entrants are all quietly dropping their currencies with the dollar to maintain competitiveness: Central Europe Currencies - The Tide Turns

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