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The Future of Euro: A View of A Concerned Outsider

English Pages, 20. 11. 2003

It is an enormous pleasure to be here today and to share the platform with so many distinguished scholars. I am afraid, however, that now, at the end of the conference, it is very difficult to come with anything illuminating or surprising. In addition to it, I have the feeling that everything what is really relevant about Euro has been already stated (and accompanied by convincing arguments). The scarce factor is not the supply of arguments but the demand for them. It was, therefore, a very good idea of the CATO Institute to express its demand by organizing this conference and by inviting us to come here. It is frustrating not to have such meetings in Europe where the arguments mostly remain at political or journalistic levels.

My own perspective is based on a special combination of three elements:

- my strong belief in the standard economic argumentation which is, in this field, summarized in the already textbook theory of the optimum currency area;

- my citizenship in a small Central European country which will be in five months a new member of the EU and sooner or later a member of the EMU. Due to it, I have an understandable personal interest in the existence of a rational and efficient monetary arrangement in my part of the world;

- my current political role which forces me to openly reveal my position on my country’s EMU membership.

My basic arguments can be summarized in the following way:

1. I am convinced that the driving force behind European monetary unification has been strictly political, not economic. This often used argument can be supported by my own experience based on numerous explicit conversations about it with key European political leaders. The economic arguments have been marginalized or taken only very superficially. The political ambition has been quite dominant. Euro has always been considered to be a useful instrument for the creation of the European political union.

Many statements of that kind can be quoted. European President Romano Prodi made it in an interview on CNN (January 1, 2002) quite explicit: “The introduction of the Euro is not economic at all. It is a completely political step…The historical significance of the Euro is to construct a bipolar economy in the world”. Two years before that, in Financial Times (April 9,1999), he said:” the two pillars of the national state are the sword and the currency and we changed that”. Gerhard Schröder in March 1998, still an opposition leader, said that “the Euro is a sick premature infant, the result of an over-hasty monetary union”. After eight months, as a German Chancellor, he made a different statement:“ Our future begins on January 1, 1999. The Euro is Europe’s key to the 21st century. The era of solo national fiscal and economic policy is over.” Spanish Prime Minister Felipé Gonzales said in May 1998: ”The single currency is a decision of an essentially political character…We need united Europe. We must never forget that Euro is an instrument for this project.” I can quote indefinitely but the words will be almost the same.

2. I believe that the largest part of the positive economic impact of European integration (as well as of EU enlargement) has come through the liberalization of trade and investment and has been already obtained. The marginal contribution of further economic or non-economic unification will be close to zero, if not negative. Because of that, the births of Euro as well as the day of the next EU formal enlargement in 2004 do not represent any breakthroughs. I agree with Patrick Minford, 2002, that „trade patterns are determined by comparative advantage, not by monetary factors“ (p. 36) and that the role of the exchange rate risk as a factor determining foreign investment and the cost of capital is relatively small (p. 29 – 32). Trade does not need to have the same currency on both sides of the transaction.

3. To look at the economic performance of the Euro-zone in the first years of Euro existence, even the pro-European activists must admit that the overall expectations of an economic boost and the claims that the introduction of the Euro would speed up economic growth have not been fulfilled. This is not a surprise for me and, to be fair, not everyone had such expectations. Rudiger Dornbusch, always sharp and consistent, whom we miss very much, wrote in 1996 that “EMU moved from an improbable and bad idea to a bad idea that is about to come true.” Many of us knew then and know now that the formation of a regional common currency is neither a necessary, nor a sufficient condition for a healthy economic growth. It seems, on the contrary, that the Europeans have imprisoned themselves in a rigid monetary arrangement, which led to a loss of a non-negligible part of their originally existing flexibility.When we look at the current European monetary and overall economic problems we have to - at least analytically - differentiate two issues: one is the impact of a monetary union upon non-identical countries, but countries that are at a similar level of economic development, another is the impact of entry into a monetary union of a country which is at a different level of economic development than the dominant part of the union and which is undergoing dynamic structural changes in an effort to catch-up with its more developed partners.

1. The Costs and Benefits of a Monetary Union among Similar but Non-identical Countries

The conditions formulated four decades ago by Robert Mundell, 1961, as regards the optimum currency area, are well known. Their fulfillment guarantees a favorable balance between costs and benefits of a monetary union, their non-fulfillment does not. They include:

- the sufficient extent of labor mobility among parts of the monetary union;

- the lowest possible degree of a wage rigidity inside individual countries;

- similar factors of production endowments and a symmetry of exogenous shocks and impulses;

- the existence of an adequate fiscal compensation mechanism.

These conditions are in Europe currently not fulfilled. Labor mobility in Europe is – as compared to other monetary unions – relatively very low and the required downward wage and price flexibility is almost non-existent. The rigidities of the European labor market are well-known and well-documented (see, e.g., Heckman, 2003), which is in a contradiction with the basic requirement, which says that where labor markets do not function well, flexible exchange rates are all important. The asymmetric shocks and impulses appear again and again, which is not surprising because the Euro-zone countries are different. The size of fiscal transfers at the EMU level is, however, very small. There exists some international solidarity among EU members but its level cannot be compared to the solidarity in national states.

The assumed benefits – the reduction in transaction costs and of exchange risk – will be in reality rather small. With the current level of financial and banking sophistication transaction costs are saved only in tourist transactions, not in other fields.

I agree with Irish economist A. Coughlan, 2003, that “the economic advantages of being able to travel within the Euro-zone without having to change currency, and of being able to compare prices more easily between Euro-zone countries, are small compared to the economic disadvantages” (p.16). I especially agree with his argument (which I myself use quite often) that “people may be on holidays in other Euro-zone countries for 2-3 weeks a year, but they had to be working for the remaining 48-49 weeks at home”. The above-average benefits can be gained exclusively by the permanently traveling EU politicians and their bureaucrats.

We should not forget that to join Euro does not mean to join a world currency but only a regional one where the exchange risk basically remains. It does not mean, of course, that I would suggest to create a world currency along the lines of recent suggestions of Robert Mundell (described in an article of H. Grubel, 2003.)

The costs of monetary unification are important. They include the loss of independent monetary policy, which mostly means the loss of interest rate setting power and the loss of the possibility of exchange rate movements. When I say this, it is not an advocacy of the policy of competitive devaluations. I don’t, however, believe that the European economies have sufficient alternative flexibility to avoid problems resulting from such a rigid parametric structure. To eliminate two important policy variables – interest rates and exchange rates – means either to rely on a textbook level of perfect microflexibility or to be prepared for large fluctuations of the real economy, or to expect the acceleration of fiscal transfers inside the monetary union.

Such perfect microflexibility does not exist. The sluggishness of domestic prices and wages forces the exchange rate to be the shock absorber, which is not the same as competitive devaluation. It is easier, stresses B. McTeer, 2002, “for your exchange rate to adjust to your economy and policies than for your economy and policies to adjust to a predetermined exchange rate.” (A. Coughlan’s arguments seem to be persuasive: “the years 1993-99 was the only period in the history of the Irish state that it pursued an independent currency policy and allowed the exchange rate to float…The intelligent use of an independent currency is the principal reason for the Irish economic boom, which has attracted such international attention in recent years” p.16).

I would like to mention two other phenomena, which I put on the side of costs. Single currency (without fiscal unification) creates environment for fiscal irresponsibility. We can even talk - together with Anthony de Jasay, 2003 - about fiscal free–riding: “Each member state of the Euro-zone is caught between two alternatives – to engage in fiscal free-riding or to be the victim of free-riding by the others” (p. 2). In the same spirit Peter Kenen rightly asked in 1996, whether the currency domain can be bigger than the fiscal domain (Kenen, 1996). I don’t think it can. When a country has its own currency, fiscal irresponsibility carries its own punishment. Such punishment does not, however, exist in the current Euro-zone. The fiscal deficits in some of those countries after the establishment of the Euro seem to support this argument.

In addition to it, European monetary unification is the Trojan horse for overall harmonization of economic rules, policies and laws in EU. I am convinced that any Euro-zone problem will be in the future interpreted as a consequence of the lack of harmonization (of nominal unification) and will lead to another wave of a creeping harmonization. Hans Eichel, the German minister of finance, made it quite clear: “The currency union will fall apart if we don’t follow through with the consequence of such a union. I am convinced we will need a common tax system” (Sunday Times, December 23, 2001). Such an unnecessary and counterproductive harmonization (and centralization), which tries to eliminate comparative advantages of individual countries, is one of the most worrying elements of the whole European integration process.

Comparing the above-mentioned costs and benefits, I am afraid that it is not true that the costs of the European monetary unification do not exceed the benefits. They do. Sluggish economic growth in Europe since the introduction of the Euro is not a proof of that, but it is not an accident either.

2. The Costs and Benefits Connected with the Entry into a Monetary Union of a Transition Country which Needs Real, not only Nominal Convergence

Eight Central and East European countries will become EU members in May 2004 and in their accession treaties with the EU, signed in April 2003 in Athens, they promised to enter the Euro-zone.

Many people in these countries look forward to it. They expect to gain from Euro stability, from decreasing the exchange rate risk, from a credible monetary policy. I am struck that they don’t see the other side of such an arrangement because it is more than evident that the transition countries need maximum of flexibility and should not introduce any artificial rigidities. They should not for political reasons take actions against their own economic interests.

The main costs for them will be the loss of independent monetary policy which should be – for the countries in transition, for the countries undergoing radical structural changes, for the countries at a lower level of economic development – visibly different from the policy of developed and more stable EU member countries of Western Europe. It makes no economic sense for them to have the same interest rate as Germany or France (not to open another topic – the fact that ECB is not subject to any democratic control and has a deflationary bias in its policy).

The same importance has for them the loss of the possibility of exchange rate movements. Transition countries are in a permanent process of real appreciation and there is no way how to make it possible with fixed exchange rates, with inflation and interest rates targets of Maastricht Treaty, and with Stability Pact conditions concerning budget deficits. There is an additional danger that there will be a very high risk of fixing the exchange rates away from long-term equilibrium because the convergence process will not be - in the moment of their entry into the Euro-zone - completed. The result will be the insufficient final exchange rates realignment (the problem we see with current Euro-zone members as well).

I repeat that I am not an advocate of misusing the exchange rate movements for competitiveness reasons. I myself at the end of 1990 radically devalued the Czechoslovak crown (but not in an attempt to gain competitive advantage) and immediately after that introduced a fixed exchange rate regime. I was afraid of setting an unsuitable exchange rate level but the belief in the use of the exchange rate as an anchor for stabilizing inflation was then overwhelming. I was aware of creating a dangerous rigidity that would constrain future responses to internal and external pressures and impulses and tried to find an optimal moment for abandoning such an arrangement. I have to admit, however, that I did not find it (the floating of the Czech crown in the spring 1997 came too late).

But such an exchange rate-based stabilization of inflation is not our current task. The rate of inflation is very low and we need flexibility in nominal variables, not their rigidity. One clever Czech economist, then deputy minister of finance, Miroslav Koudelka, made 35 years ago a point which I still remember: “when everything is frozen, you may go skating but you cannot run a rational economic policy.” It was an argument used in the Czechoslovak economic reform debates in the sixties and I believe it is valid now as well.

Rigidities of a monetary union and a growing implicit macroeconomic disequilibrium will block real convergence and will create “transfer economies” (like East Germany after reunification, H. W. Sinn, F. Westermann, 2001), which will be, however, forced to exist without adequate fiscal transfers because they are - in the contemporary EU - not available.

My conclusion is that there is no need for these economies to rush into the Euro-zone.

3. The Future of EURO

Euro is here and is here to stay. I do not expect its end even if I know that it is relatively easy to dismantle a monetary union. My own experience with the termination of the Czechoslovak monetary union in February 1993 suggests that it can be done without serious costs, smoothly and efficiently.

I expect, however, that to keep the European single currency will be costly in terms of economic growth and in terms of inevitable fiscal transfers aiming at compensating the weaker partners. It may even generate unnecessary tensions among nations. We should be aware of it.


Coughlan A., Some Reasons why Joining the Euro has been a Mistake for the Republic of Ireland, The European Journal, Vol. 10, No. 8, July 2003
de Jasay A., Free-Riding on the Euro, The Library of Economics and Liberty, September 17, 2003
Heckman J. J., Flexibility, Job Creation and Economic Performance, Paper presented at the Munich Economic Summit, May 2, 2003
Kenen P. B., Sorting Out Some EMU Issues, Reprint No. 29, December 1996, Princeton University
McTeer B., A Skeptical Texan Wishes the Swooning Euro Well, European Affairs, Spring, Vol. 1, No. 2, 2002
Minford P., Should Britain Join the Euro?, IEA, London, 2002
Mundell R., A Theory of Optimum Currency Areas, American Economic Review, Vol. 41, No. 3, 1961
Sinn H. W., Westermann F., Two Mezzogiornos, CESIFO Working Paper Series, No. 378, 2001

Václav Klaus, CATO Institute, Washington D.C., 20. November, 2003

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