NOTES ON EUROPE, EURO AND EMU
Stern School of Business
New York University
We have recently observed been a major reversal of
the economic fortunes of Europe, Japan and the U.S in the 1990s.
Only a few years ago, the US
economy appeared as affected by a serious malaise: low growth, a sharp
recession in 1990-91, large trade imbalances, a weak dollar, a hollowing
out of the manufacturing sector and persistent talk of a structural decline
of US power.
Conversely, Japan was
viewed as an exemplary economic success story and a model of successful
economic long-run growth. People talked of "Japan Inc." and the Japanese
growth model was being suggested as a case study to be followed by other
Asian and developing countries.
Europe had not been as
successful as Japan but the overall economic performance of Europe in the
1980s was at least as good as the one of the U.S. Also, the 1992 Single
Market project and the prospective of a European Monetary Union (EMU) energized
the European continent in the early 1990s and led to a phase of Euro-Optimism
after a long period of Euro-Pessimism in the 1980s.
Today, the situation appears
almost exactly reversed.
We have seen four year of serious economic recession
and turmoil in Japan from 1992 to1995 only partly reversed in 1996. The
recovery has stalled in 1997. The Japanese model does not work anymore
even in Asia (see the recent currency and economic turmoil in East Asia).
Europe has been growing very slowly in the 1990s and
high unemployment rates remain a serious issue; also, there is skepticism
and many doubts about wisdom of a monetary union in Europe.
Both Japan and Europe seem afflicted by structural
Conversely, the US has had five years of dynamic economic
performance and competitive resurgence. Because of a dramatic restructuring
process over the last decade the US economy is now "lean and mean", highly
productive, with low labor costs, highly innovative and very competitive
in world markets.
Talk about a "new era", "new paradygm", "new economy",
The US was ranked #1 in competitiveness according to
the recent "World Competitiveness Report"; Japan #9; Germany #14 and France
#20; Italy #34.
2. Features of the European Economic
A very extensive welfare state with a central role of
the government in regulating markets and economic activities. Public provision
of many services: education, health, pension systems, unemployment benefits,
wide range of social insurance programs.
Large size of government spending (on average 50-60% of
High tax rates to finance such welfare state.
Regulation of labor markets, strong labor unions and extensive
benefits for workers.
Regulation of product markets and existence of oligopolistic
Heavy use of industrial policies to foster national industries.
Relatively open trade regime (at least within Europe)
and open policies towards FDI.
Limited capital and labor mobility within Europe.
A large public enterprise sector.
Is the traditional economic model
of Europe now partially flawed and in need of structural change and reform?
Simple answer: Yes. Why?
3. Serious labor market rigidities
Labor market rigidities in Europe:
Excessive regulation of labor markets.
High taxes that discourage job creation and job search.
Excessive job security.
High levels of unemployment insurance.
Excessive fringe benefits (above wages) that increase
High severance benefits.
Union strength leads to power for "insiders" (job holders)
relative to "outsiders" (the unemployed).
Flat wage differentials not rewarding sufficiently productivity.
4. Fiscal policy problems
Excessive deficits in Europe in the 1970s and 1980s led
to high public debt (as a share of GDP)
Fiscal retrenchment in the late 1980s and 1990s
The Maastricht fiscal criteria imposed extra fiscal discipline.
The fiscal adjustment in Europe has been difficult and
painful because of slow growth and high unemployment
The long-term problems of fiscal policy have not been
The aging of population has led to:
Large unfunded future liabilities of
the public pension system.
Large unfunded liabilities of public
health care systems.
Other long-term issue: fiscal burden of extensive welfare
Still limited privatization of public enterprises in Europe.
The above long-term problems are more serious in Europe
than the US.
In US you had welfare reform, Medicare and Medicaid budget
cuts and the Social Security imbalance is not as serious as in Europe.
Very limited structural fiscal reform so far in Europe.
Trends in the Global Economy
and Challenges Faced by Europe:
Structural changes in the nature
of technological innovation
Globalization and greater trade
Deregulation policies fostering
5. Structural changes in the
nature of technological innovation.
The nature of technological innovation has changed. From
the 1950s until the early 1980s, innovation took the forms of already existing
technologies and goods that had to be improved in quality (examples are:
cars, stereo systems, photographic equipment, other consumer electronics
The Japanese were best at doing this as being the best
in "process innovation", "quality improvement" and "product imitation".
Today, technological innovation is very different because
of qualitative changes in technologies and the rapid appearance of new
and very different products (computers, software, Internet and information
technologies, advanced chip technologies, telecommunication goods and services,
new financial instruments and services). These products are appearing and
changing at such at dizzying pace that an imitator cannot catch up with
the product and technological leaders.
The product cycle of innovation has become drastically
shorter. Extreme example: the Internet Browsers and the war between Microsoft
and Netscape. So, today you either innovate and remain on the cutting edge
of the technological wave or you risk to remain forever behind.
A mainstream view in the United States right now is that
in all these new technologies and products Europe (and Japan) are seriously
behind the US and may have a hard time to catch up.
In terms of technological innovation, Europe is currently
lagging behind both the U.S. and Japan.
6. Globalization and greater
Increased global trade and lower tarriffs have led to
global competition and the need for industrial restructuring.
The US suffered in the 1980s from freer trade, trade competition
and the strong dollar value but this major economic shock led to a dramatic
process of corporate restructuring.
Europe was relatively open to trade but followed trade
policies that were overall more protectionistic than the US, especially
towards non-European countries ("Fortress Europe").
However, the 1992 Single Market project (and EMU) will
eventually lead to the elimination of barriers to trade in goods, services
and factors of production (capital and labor) within Europe.
7. Deregulation policies fostering
Since the early 1980s the US experienced a major process
of economic "deregulation" in all sort of sectors of the economy including
manufacturing goods, services, traded and non-traded goods. Such policy
of deregulation led to competition, pursuit of efficiency and major economic
In Europe, the 1992 Single Market project should lead
to significant deregulation and increased competition. The deregulation
process has however been much slower than in the US.
8. Corporate restructuring
The combined forces of:
led to major Corporate Restructuring
in the US that took the forms of:
Global Trade Competition
Deregulation of the economy
c. Large scale Downsizing of firms
d. Massive corporate control restructuring through
Mergers and Acquisitions, LBOs and Takeovers
Because of this dramatic restructuring over the last
decade the US economy is now highly productive, with low labor costs, innovative
and competitive in world markets.
9. Costs of this corporate restructuring
Of course, there were very high socio-economic costs
of this restructuring process first for blue-collars and now for white
collars and managers:
a. Major job turnover
b. Great job insecurity
c. Need for disrupting occupational and regional mobility
d. Little real wage growth for average workers
e. Increase in income and wealth inequality
However, such corporate restructuring has led to:
higher productivity growth,
a resurgence of manufacturing,
high employment growth
low structural unemployment rates
10. Europe's Response to Global
Monetary discipline and low inflation.
Maintenance of labor market system where the "insiders"
are guaranteed jobs and high real wages but they have to pay high taxes
to support the "outsiders" (i.e. unemployed). Consequence: chronic unemployment
Very limited reforms in the direction of reducing the
role and size of the welfare state.
Very limited privatization of public enterprises.
Single Market project for deregulation and competition.
Maastricht fiscal discipline but no long-run structural
European Monetary Union (EMU) project
View of Stephen Roach: "The road to European and Japanese
competitive revival is going to be a lot longer and more arduous than which
the US has traveled since the early 1980s" (Financial Times, October 22,
11. Costs and Benefits of EMU
Lowering of transaction costs in trade
Elimination exchange rate risk in Europe
Greater goods market integration and competition
Broadening and deepening of integrated European financial
Preservation of inflation discipline if ECB is independent
Maintain fiscal discipline with "Growth and Stability
Make more urgent the need for structural reforms in Europe.
Possibility of asymmetric shocks that require the use
of exchange rate adjustment.
No monetary autonomy that might fine tune national shocks.
Limited labor mobility and structural labor market rigidities
imply that Europe may not be an optimal currency area.
Little room for fiscal policy as a stabilization tool
in the absence of independent monetary policy
No central system of federal taxes and transfers to insure
against regional/national shocks.
Monetary policy may work in short-run, not long-run.
Limited role for fiscal policy in Europe.
12. Euro/Dollar Relations
Features of an international
1. Means of payments role.
Official use. Reserves of
central banks. Vehicle currency and intervention currency. Possibility
of greater diversification away from US$ towards the Euro. Risk-reward
considerations. Role of low inflation.
Private use: it depends on
thickness externalities in payments systems. Increasing returns to scale
in payments. Incumbency advantage and inertia favoring the US$. Greater
future use of Euro. Important role of the attitudes of traders in the inter-bank
2. Unit of Account Function
Invoicing of imports and exports. Present dominant role
of US$. Invoicing mostly in Euros within Europe. Possible greater use of
Euro in Central and Eastern Europe, Middle East Region and Africa. Unlikely
use of Euro for primary commodities.
3. Store of value function
Will some countries peg their exchange rate to the Euro
rather than the US Dollar? If, yes greater use of Euro as an intervention
currency increasing official demand for Euros.
Will public and private investors hold a larger fraction
of their portfolio in assets denominated in Euros? If yes, large portfolio
shifts leading to greater demand for Euros and causing a Euro appreciation.
Higher use of Euros in portfolios will depend on economic
factors (inflation, value of Euro relative to US$ and Yen, growth in Europe)
and political factors.
Scenario for Euro/$ rate: Greater use of Euro in its
three functions will make it an international currency competing with US$.
Effects of this:
Initial appreciation of Euro relative to US$ as Euro demand
exceeds its supply. Overshooting relative to its long-run value.
Initial improvement of Europe current account balance
because of J-curve effects.
Worsening of current account over time as the effects
of the real appreciation occur.
Financing of the current account deficit through capital
account. This will increase the supply of Euro assets.
As the Euro overshot its long-run value and the current
account worsens, the Euro will depreciate.
Europe may not like a Euro appreciation because of European
unemployment and could prevent it through easier monetary policy.
The Euro may start weak and low growth in Europe may lead
to a loosening of fiscal policies. Euro may be perceived as weaker than
DM. Caveat: ambiguous effect of fiscal policies on the exchange rate.
Political factors (see France and Club Med in EMU) may
make the Euro a weak currency. Political conflicts within Europe will not
The structural weakness of the European economies will
lead to a relative weakness of the Euro.
Caveat: The ECB will be forced to show its credibility
and build the reputation of the Euro by keeping monetary policy tight in
the early stages.