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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