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August 15, 1997
"Euro No Magic Wand for European Unity"
San Jose Mercury News
By Timothy Taylor
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THE POLITICAL reasoning behind the drive for a single European currency, to be called the euro, is clear enough. The euro represents the idea of a unified Europe -- at least unified enough that Germany won't again go to war with France. Moreover, many nations of Europe are peeved that Germany now effectively sets monetary policy for all of Europe, since they feel compelled to adjust their own currencies according to the German mark. They hope that the institutions of a joint European currency would offer them a chance for greater policy input.

But in pure economic terms, the case for the euro is surprisingly fragile. It boils down to two arguments. A clearly correct reason is that a single currency will encourage cross-European trade, by eliminating the costs of switching between currencies and the risk of currency fluctuations. A second, more disputable reason is that individual European countries have all too often mismanaged their own currencies, leading to inflation and economic volatility, and that this would be less likely to happen continent-wide with the euro.

The intellectual framework for balancing these advantages of a single currency against potential disadvantages was first laid out by an economist named Robert Mundell back in the early 1960s. The theme is that when countries have different currencies, the exchange rate offers a mechanism for adjustments when economic factors in different areas head in opposite directions.

To understand what happens when a single currency eliminates this adjustment mechanism, consider what happens in the United States when a particular state, say California, goes through rocky economic times. People move out of California to other states. Prices of real estate in California drop. Pay increases in California become scarce; layoffs and pay cuts become more common. As incomes fall, Californians pay less in federal taxes and receive more support from federal welfare programs, which helps to cushion the bad state economy.

In Europe, these adjustment mechanisms don't operate nearly as well. If the economy of Portugal is suffering, you don't see a lot of Portuguese moving to Ireland or Sweden. Prices and wages across Europe are far more regulated than in the United States, so they do not fluctuate as freely in response to economic conditions. Since Europe's central government remains small and weak, it offers little cushion to a national economy suffering a downturn.

Moreover, the United States is a relatively unified economy already, where macroeconomic facts like inflation, unemployment, productivity, and recession in different regions have some tendency to rise and fall together. The nations of Europe are far less unified economically, and so the need for adjustments between regions is correspondingly greater. Thus, a common currency works fairly well across the states, both because they are already part of an economy that moves largely in unison, and because labor movement, prices, wages, and government fiscal policies help adjust for economic differences that do occur across regions.

In contrast, the nations of Europe do not have economies that move as much together, nor do they have the other economic and government mechanisms for adjustments across regions. Trying to force a single currency on the nations of Europe is not likely to work well in economic terms. Instead, when a European nation suffers from high inflation or low productivity, the existence of the euro will prevent its economy from adjusting by depreciating its currency. Lacking other adjustment mechanisms, bad economic times and high unemployment in that nation will be more likely to continue.

Nonetheless, the euro is still likely to be enacted in some form. Many European leaders see the euro as a symbol of a resurgent Europe. They envy the global prominence of the U.S. dollar, and apparently believe Europe would be a unified global power if only it had the euro. But a single currency would make more sense if the European Union first harmonized the continent's laws on taxes, spending, regulation, migration and trade -- not to mention foreign policy and defense. The euro is no magic wand for avoiding the hard work of creating a unified Europe.

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