The euro was born out of America's abuse of the dollar's supremacy in the global financial system. The single currency will challenge that supremacy, but will still benefit America. And until the euro acquires a political voice, Europe will continue to play a support role to the US in world affairsby Martin Walker / January 20, 1999 / Leave a comment
Published in January 1999 issue of Prospect Magazine
As the euro is born, Europe’s political class worries about its immediate prospects. Will it be “hard” or “soft”? What form of economic governance will it require? When will “outs” become “ins”? But there are also strategic questions which attend the euro’s birth, in particular the impact it is likely to have on relations between the two richest and most powerful entities on the planet-the US and the European Union.
It is too easily forgotten that one of the main inspirations behind the euro was the resentment felt by most of Europe over the US’s misuse of the dollar’s supremacy in the global financial system. The story begins with the Tet offensive in that extraordinary spring of 1968. The Vietnam war was creating balance of payments trouble for the US, which it met by exporting dollars to Europe. The Tet offensive delivered a serious blow to US arms, and led to President Johnson’s decision not to seek re-election. He also refused to deepen US opposition to the war by raising taxes to pay for it. Thus, the rising cost of the war led to a federal budget deficit of $24.2 billion in 1968, more than the total deficits of the previous five years.
Europeans felt that they were financing US budget deficits and suffering the consequences of the export of US inflation, while at the same time seeing their companies bought up by the export of US capital. This was the period when Jean-Jacques Servan-Schreiber’s polemic Le D?fi American (The American Challenge) became a bestseller across a Europe in which anti-Americanism was made respectable by the Vietnam war and race riots in US cities.
Charles de Gaulle’s response was to send the dollars back to the US and demand gold in return. In the single month of November 1967, when devaluation of the British pound began to destabilise the Bretton Woods system, the “gold pool” had to sell $700m to hold the price. Two days later, De Gaulle announced that France would no longer participate in the pool, and the US was forced to stop selling gold into the free market. Only central banks were now permitted to buy the metal. The system, however, was still vulnerable to political storms.
In August 1969 the French franc was devalued by 11 per cent and in September, after strenuously resisting US demands that the Deutschemark be revalued, the Bundesbank agreed to float it; and the following month it was revalued by 9 per cent. A European political generation never forgot what they saw as the manipulation of their currencies to ease an American balance of payments crisis to pay for a war which few of them supported.
The European Community was then limited to the original six: France, Germany, Italy and Benelux. In this atmosphere of currency crises, Raymond Barre, a future prime minister of France and at the time European commissioner for financial affairs in Brussels, wrote a report on how a single currency could protect Europe from these Anglo-Saxon disruptions. This led in turn to the “Six” commissioning Pierre Werner, the veteran prime minister and finance minister of Luxembourg, to produce a detailed plan for economic and monetary union.
A direct line of descent runs from the Barre/ Werner reports to the euro. It comes via President Nixon’s killing off the Bretton Woods system in 1971, the conversion of German Chancellor Helmut Schmidt to the single currency idea, and then the various ante-chambers to the euro-the European currency unit, the European monetary system and the ERM-and the final political push provided by German unification, leading to the Maastricht treaty.
But by undermining the strategic loyalty of its European partners through abuse of the dollar in the period 1968-73, and again from 1979-82, and from 1985-89, the US government is the true father of the euro. From the start Europeans saw the euro not only as a means to build Europe, but also as a defensive measure against the dollar’s disruptions. (This policy combination fuelled British unease about the project, which in turn hindered the process of European integration. Margaret Thatcher, who saw British and US interests in Europe as almost inseparable, and made no secret of her preference for a strong Atlantic alliance over a strong Europe, finally broke her political career on the issue.)
But, regardless of the spirit of anti-American resentment which inspired the euro, the currency has (notwithstanding some recent anxieties) attracted strong official support from recent US administrations and will be in the US’s national interest.
The coming of the euro, based on a European economy which matches the US in size and in share of world trade, should dampen the violent currency fluctuations which have repeatedly seen 50 per cent swings in the dollar:yen and dollar:Deutschemark rates. An end to these gyrations will be good for the global economy, good for the US and good for the Atlantic alliance. It will involve a sobering, although not humiliating, decline in the dollar’s prestige-a small price to pay for the benefits involved, if the adjustment process is pursued with care and forethought. This adjustment will not happen quickly, because while the euro has a central bank, it deliberately does not have an equivalent of the US Treasury, which can speak and act for the dollar in global affairs. Indeed, until the euro gets similar political leadership, the dominance of the US in global financial stewardship is likely to continue by default.
on 1st january 1999, 11 European countries formally adopt the euro as their currency for banking purposes; and government accounts will be kept and government debt issued in euros. Citizens and companies may pay their taxes and invoiced bills in euros, which will eradicate the costs and risks of trading foreign exchange. Their national currencies will continue to operate alongside the euro until the spring of 2002, when the euro’s notes and coins go into circulation. And 11 mighty and historic currencies will go the way of the doubloon and the thaler.
The British government has said that it has decided in principle to join-when its place on the economic cycle is more coordinated with that of the rest of the EU, and after an election and a referendum. The likely timetable is for the next British election to be held early, in the spring or summer of 2001, to be accompanied or swiftly followed by a referendum, which would allow the pound to join the euro in time for the circulation of notes and coins in 2002.
Even with the four absentees-Britain, Sweden, Denmark and Greece-the Euroland of 11 countries and 290m people can claim to be the world’s greatest trading power. Their combined exports are 25 per cent greater than those of the US and double those of Japan. The combined GDP of Euroland in 1997 was 19 per cent smaller than that of the US, but 50 per cent higher than that of Japan. Euroland will be an important force in the global economy and in world trade, and discreet diplomacy by the European monetary affairs commissioner, Yves-Thibault de Silguy, has elicited undertakings from Japan, Brazil, Taiwan and China that a significant and increasing proportion of their foreign reserves will be denominated in euros. The 15 EU members provide 30 per cent of the IMF’s resources-more than the US and Japan combined-so Euroland’s influence in the IMF should at least match that of the US.
For the immediate future, the dollar will continue to be the world’s dominant reserve currency. The importance of the US financial and futures markets means that commodity and energy prices will continue to be set in dollars for some time to come. But the current dominance of global finance by the dollar will certainly come under challenge. Indeed, in some important areas-such as international security issues, foreign holdings of bank deposits and denomination of world exports-the dollar’s role is already rivalled by that of the combined EU currencies.
The crucial area, where immediate change can be expected, is in official foreign exchange reserves. In 1995, according to figures compiled by the US-based Institute for International Economics, 64.1 per cent of these reserves were denominated in dollars, 15.9 per cent in Deutschemarks (21.2 per cent in all EU currencies combined), and 7.5 per cent in yen. The institute’s director, C Fred Bergsten, estimates that “the dollar and the euro are each likely to wind up with about 40 per cent of world finance, with about 20 per cent remaining for the yen, the Swiss franc and minor currencies.” (That 20 per cent for the rest may shrink significantly after the EU-Swiss negotiations of 1998, which cleared away most of the remaining obstacles to Switzerland joining.)
Assuming that Bergsten is right, an unprecedented shift in the world’s financial resources should soon get under way. Bergsten estimates that between $100-300 billion of official reserves are likely to shift from dollars into euros-and between $350-700 billions in private assets. He calculates that something between $500 billion and $1 trillion is likely to change monetary allegiance. The crucial question is: how long will this take? Done too fast, the effect will be like a tsunami, driving down the value of the dollar and inflating that of the euro. Carefully coordinated, and extended over some years, the effect should not be dramatic.
It is conceivable that the euro may prove a more popular reserve currency than the dollar. As a new currency, it has to establish its credentials as a reliable store of value, more like the Deutschemark than the lira. This implies that its interest rate will be competitive. The euro will be run by a wholly independent European Central Bank (ECB), directed (at German insistence) by the former Dutch (socialist) finance minister and central banker, Wim Duisenberg, a great admirer of the Bundesbank’s anti-inflationary tradition. The founding statute of the ECB requires it to run the currency with price stability as its main priority, and with very little transparency about how it does so.
As and when Britain, Sweden, Denmark and Greece, and then possibly Switzerland, formally join Euroland, the balance of economic power will shift more strongly towards the euro. It is likely that within five to ten years, oil and commodity prices will be priced in both dollars and euros. This should have no harmful effects on the US economy, except for some loss of seigniorage (the fact that anyone who holds a foreign currency banknote is in effect making an interest-free loan to the issuing central bank). Seigniorage is reckoned to be worth $30 billion a year to the US Treasury, in part for the unwholesome reason that the $100 bill is popular among drug traffickers and money launderers. This role is likely to be challenged by the 500-euro bill, which will be worth $550. It takes a briefcase to carry $1m in $100 bills, but a breast pocket will do for an equivalent sum in euros.
The real cost to the US will be that the progressive loss of its unique status as a reserve currency will mean less and less power to abuse its position. The US will no longer be able to devalue painlessly, by printing and exporting dollars into the Eurodollar market. It will no longer be able to bully its partners in Europe and Japan into revaluations to help the US balance of payments, as it did in 1969-71 and 1985-87. It will no longer enjoy sole status as a safe haven currency in times of unrest. It will have to compete for this role with the euro, at a time when the importance of Euroland as a market and as an exporter will require many countries and corporations to hold euros for routine trading.
The more stable the euro proves to be, the more the dollar will be required to show similarly sound stewardship. If the dollar is seen as more likely to suffer inflation, then it will sink against the euro unless compensation is paid in the form of higher US interest rates. This could be a problem, because the US has run current account deficits for the past 15 years. Net foreign debt is more than $1 trillion, and rising by over 15 per cent a year. All this is quite manageable in an economy with an annual GDP of $8 trillion. But when the dollar is competing as an international store of wealth with the euro, whose Euroland current account has been in balance for many years and which usually runs small surpluses on its international accounts, then the dollar faces an uphill fight for credibility. In short, the mere presence of the euro means that the dollar is on a kind of probation. It will have to learn to behave. Its managers, not just in the Federal Reserve and the US Treasury, but in the political engine rooms of White House and Congress where fiscal policy is set, will have to operate as Thomas Jefferson intended: “With a decent respect for the opinions of mankind.” The dollar’s international credibility (and thus its value) will be at risk from popular but financially questionable tax cuts, or from recurrent federal budget deficits.
Dollar loyalists should not think that they are alone in paying a price for the launch of the euro. It should have a jolting effect on the rigidities of Europe’s labour markets and on the unwritten price cartels which allow European business to shift profits to low-tax countries while cutting them in high-tax ones. (The record-breaking fine imposed on Volkswagen this year by the EU commission for price-fixing in Italy, should no longer be necessary when European consumers will be able to make instant euro-price comparisons.)
One unwritten motive behind the euro has been to Thatcherise Europe by the back door, and to achieve a comparable shift in the balance of power between labour and capital. Thatcher did it by confrontation. Most of Euroland is richer and more consensual than Britain was in the late 1970s; and has been able to reform more gently and in the name of the European ideal. But cuts have been imposed on government spending and taxes have risen to allow once-profligate social market economies to cut their budget deficits to the targets required in the Maastricht treaty, of 3 per cent of GDP, and total government debt to 60 per cent of GDP. (Belgium and Italy, whose debt is at twice this level, were given a waiver on the grounds that their budgetary discipline was cutting these monstrous debt levels fast enough.)
Euroland governments have gritted their teeth and withstood unemployment rates which rose to 13 per cent in France and 12 per cent in Germany. The result has been an increase in part-time jobs, and of the black economy, as employers and employees conspire to avoid the high payroll and social taxes. The EU statistical body, Eurostat, estimated in 1998 that up to 10 per cent of the EU economy is off the books.
The euro is intended to make Europe’s economies look more like the US, with greater flexibility, higher productivity and payment by results, in an economic culture more entrepreneurial in spirit. But in turn, as the competition intensifies for the approval of the world’s money markets, the dollar is going to have to start acting rather more like the Deutschemark, or pay the interest rate penalty. A global economy which rests on two stable and anti-inflationary financial managements should benefit both. This helps to explain why US policy-makers have continued to welcome the euro, just as leading European politicians have stressed the mutual benefits.
there is, however, an important piece of the euro missing. So far there is no mechanism for its political management-either internally or externally. The only political authority is Ecofin, the council of finance ministers of the 15 EU member states. There is also a less formal Euro-XI committee, where the finance ministers of the 11 euro members will meet. But in response to British objections at being left out of this inner circle, Euro-XI will have no permanent secretariat and its meetings will be prepared and staffed by officials from Ecofin, while Ecofin’s chairman rotates every six months among the member states, along with the presidency of the EU Council.
Who will speak for Europe at a time of international financial crisis? An emergency meeting of Ecofin can be called, but can hardly provide day-to-day crisis management. It is far from clear that any single political authority in Euroland will have the power, let alone the experience, to launch a big rescue in the way that the Clinton administration bailed out the Mexican peso in 1995. Management of the Asian financial crisis of 1997-98 has been led politically by the US Treasury secretary, who had the authority in June 1998 to launch a market intervention in order to shore up the tumbling yen. (The Europeans were not even consulted by the US before the intervention.)
For the foreseeable future, habit and convenience mean that the US will probably continue to fill the leadership vacuum, and the EU will continue to play the curious double role of economic giant and political dwarf. This is not healthy, and probably cannot last. It is in the US’s interest to encourage Euroland to devise a counterpart for the Treasury secretary, to share crisis management responsibility.
The “domestic” governance of the euro is also uncertain. The law as enshrined in the Maastricht treaty appears clear. The ECB is in charge of the interest rate and the money supply. The European council of ministers is in charge of the exchange rate and the “external representation” of the euro. But this question of governance has recently become more problematic. The euro was designed by mainly conservative governments for an inflationary age. After the French and German elections of 1997-98 it is now being run by left of centre governments in a potentially deflationary age. A conservative car driven by social democratic drivers is not necessarily oxymoronic. Europe’s social democrats have had a lot of experience in running capitalist systems, and can claim over the decades to have both civilised and improved them. Moreover, the executive authority and clear political independence of the ECB means that the governments of Euroland are, at best, back-seat drivers. They may be vocal and unruly, but their hands are quite some way from the controls.
There are five traps for the euro which will have to be negotiated in the crucial transition period between the launch on 1st January 1999, and the coming of euro notes and coins into European pockets in 2002. This transition will take place in a difficult period, following on the Asian and Russian financial collapses, and with global markets in febrile mood. At the time of writing, Spain, Ireland, Finland, Portugal and the Netherlands are all booming. France and Belgium and Austria are in a phase of apparently stable growth. Germany’s recovery is stuttering, thanks in part to slower world growth, and Italy is stuck in low growth. Euroland’s interest rates are supposed to converge at roughly the current German rate of 3.3 per cent for the single currency’s launch. This will be uncomfortable for the booming countries, and could require some fiscal discipline to prevent overheating. Given the virtual disappearance of inflation in Germany, 3.3 per cent may be too high if its economic recovery is to reignite. So the first problem will be to find the right interest rate, and the correct fiscal balance in those countries which are growing at an unsustainable rate.
The second trap concerns exchange rate gyrations. Dollar and yen rates against the euro may prove turbulent as the world markets get used to the new currency, and try to judge whether it will be run by central bankers. Will it act like a big Deutschemark, or will it be run politically by social democratic governments and behave like a giant lira? Even more tricky could be the exchange rates against sterling and the Swedish krona-for a reason which has not yet been sufficiently understood. Once the euro is launched, European banks are poised to invade the British and Swedish domestic markets with attractive offers for home mortgages and credit cards, based on low euro interest rates. With British rates twice as high as those in Euroland, there will doubtless be many takers. A fall in the sterling exchange rate could thus be painful for those borrowing in euros. That handful of British home-buyers who took out Deutschemark mortgages when Britain was in the ERM saw their real debt balloon by nearly 50 per cent after sterling’s eviction in September 1992. On a large scale, this could have serious political effects.
The third trap to beware of is political panic about some of the longer-term implications of the euro for further harmonisation of European economic and fiscal policies. Clearly some degree of fiscal coordination in Euroland is necessary, economists of all persuasions are agreed on that; the trick is to manage it through peer group pressure and consensus rather than regulation. But the wave of alarm which swept the British media in November 1998 about harmonised EU taxes was fundamentally silly. A single EU tax system is not inevitable. Even in a federal state like the US, with a common currency and common federal tax system, there are enormous variations in state taxes. Citizens of Florida and Texas and New Hampshire pay no state income tax at all. Those in New York, Connecticut or Washington DC face state income taxes as high as a third of the federal income tax. There is no consensus yet on the horizon for a common EU tax system-nor need there be: just ask Texans. That does not mean that nothing can or should be done. All the EU member states agreed in December 1997 to devise together ways of avoiding harmful tax competition within Europe. They will do this in the usual way, bickering and haggling their way to a consensus-taking account of special interests such as Britain’s concern for the City of London. They also agreed to try to prevent EU residents using tax havens such as the Channel Islands, Luxembourg and Liechtenstein. Good luck to them.
The most serious trap of all, because it will be the most difficult to avoid, is to prevent the euro from becoming a scapegoat for bad decisions by national politicians. We have seen the first signs of this in the rhetoric of Oskar Lafontaine, calling in his first weeks in office for targeted exchange rates, lower interest rates and Keynesian-style public spending to create jobs. His advisers have also hinted that the Stability and Growth Pact-designed to limit deficit spending, especially in the weaker EU economies-should be abandoned. Lafontaine and his advisers are entitled to talk like this, and there is no reason for the ECB to listen, far less obey. In the long term, governments will be able to influence the ECB because they appoint their national central bankers who will sit on the ECB board-the German choice to replace Hans Tietmeyer at the head of the Bundesbank next year will be interesting. But it is proper in democracies for elected governments to have some strategic, if not tactical influence on those who set the monetary policy. Alan Greenspan did not come from nowhere to run the Federal Reserve; he was appointed, subject to Senate confirmation, by President Reagan and re-appointed by President Clinton.
The worry about Lafontaine’s statements is not that they presage a Europe under profligate new socialist management. Other statements from the French, Italian and Spanish governments and from the German Chancellor Gerhard Schr?der make it clear that Oskar does not speak for them. The real problem is that Lafontaine may have been speaking out not just from conviction but from political ambition. This suggests a divided and weak German government, which will not inspire great confidence just as the euro is launched and as Germany is about to assume its six-month term in the EU presidency. As Margaret Thatcher and John Major discovered, domestic party politics can often intrude upon the meta-politics of the single currency.
there are, clearly, risks involved in the euro: internal risks which could destabilise the project; and external ones whose impact could be much wider. The internal risk is plain enough: the political difficulty in a democratic system of imposing a one-size-fits-all monetary policy on such different economies at such different points in the cycle. After some years of strong growth, Finland and Ireland were overheating in the summer of 1998; left to themselves, they would have increased interest rates to dampen demand. But as Euroland members, they cannot unilaterally increase rates. Any cooling down will have to be imposed through higher taxes or wage restraint-and with the Finns facing an election, higher taxes look unlikely. Any Finnish or Irish plea for higher euro interest rates would run up against German and French opposition, because their economies have only recently started to grow again. Until the convergence of Euroland’s economies is more advanced, handling this kind of asymmetry-without the US habit of travel from bust-town to boom-town, or the income transfer from booming to depressed regions which is inherent in the federal tax system-will be the central political problem of the EU.
The external risk of the euro has been emphasised by Harvard’s Martin Feldstein, in an extraordinary essay in Foreign Affairs called “The Euro and War.” He suggested that the economic and financial rivalries inherent in the euro area, not to mention the euro-dollar tension, could eventually lead to conflict. Theoretically a booming Germany and a bust France could pursue their divergent economic needs to the point of war. But it will be easier for one of them to drop out of the euro, or for the rest of Euroland to devise ways to resolve the problem before it gets out of hand. The EU has so far proved rather good at this. Feldstein’s argument also suffers from the fact that the only real experience of a dual system of reserve currencies did not lead to war between Britain and the US in this century, but to a strong and durable alliance.
Considering the potential for transatlantic rivalry, Feldstein also forgets that the inheritance of today’s integrated Europe includes 50 years of US support. Americans should take pride in the way that the Marshall Plan, Nato, and the long history of the world’s most successful alliance have produced a partnership which largely runs the world through joint dominance of the G8 and IMF and the UN security council. Gratitude is not a common European trait, but the Europeans-with some testy exceptions-have, by and large, lain back and enjoyed American hegemony. Perhaps the Europeans have had little choice; and it is conceivable that a prolonged period of mishandled crises and a global slump could strengthen the hand of those who say that the whole point of the euro is to give Europe some independent strategic choices away from the US’s coat-tails.
“We should be aware that the tendency in America is to distance itself from Europe. In the long term, Europe will therefore have to give itself the means of its emancipation,” argued the editor of Le Monde, Jean-Marie Colombani, in February 1998. “For the time being, it would do well to realise what is going on. By way of Nato enlargement to central Europe, Washington is seeking two privileged allies: Poland in the east, Britain in the west. Its goal is well-known: the undoing of assertive policies in the EU, and the rejection of a political Europe led by France and Germany, in favour of a Nato under US-British control.”
A similar point was put by Helmut Schmidt, who told the Washington Post in March of this year: “Americans do not yet understand the significance of the euro, but when they do, it could set up a monumental conflict. The arrival of the euro will imply that the overriding importance of the dollar will be reduced in the world. And it will change the world situation so that the US can no longer call the shots.”
This depends on what is meant by “calling the shots.” The US has exercised a spasmodic, sometimes clumsy but usually benign hegemony. Its power has been exercised with restraint. It has learned to live with rogue states and has toppled neither Colonel Gadafy nor Saddam Hussein. The US calling the shots may have chivvied the world to help bail out the Mexican peso in 1995, but proved rather less successful in pushing Japan towards the reform agenda that could steer it out of recession. It has not been the modern US tradition to “call the shots” even when other nations behave in a particularly exasperating way, be it Russia in Chechnya, China in Tiananmen Square, Japan over exports and France in general. The US may disapprove. It may apply some sanctions. It is famously reluctant to go to war. When the US has taken the military option, in the Gulf and in Bosnia, it has been careful to do so with a UN mandate.
Pessimists recall those mistaken forecasters of the Edwardian era, who asserted that war had become impossible in a world so civilised and interdependent through trade, a world in which imperial Britain was the biggest market for the Kaiser’s Germany and the Reich was the second biggest market for the British Empire. Pessimists about transatlantic relations might also point to the loosening of allegiances brought about by the end of the cold war. No longer cowed by the threat from the east, and less inclined to feel economically inferior to the west, the nations of the EU are freer to develop their own grand strategies and to become (for the first time since 1941) subjects rather than objects in their own dramatic narrative.
Yet the EU has chosen to maintain and nurture the transatlantic alliance. Tradition, habit, economic self-interest and shared values have all played a part in this-as has war in Bosnia, which brought home to Europe the limit of its own military and strategic capabilities. The Bosnian debacle reinforced the lessons of the Gulf war: the US is still the strategic master. Europe adopted the role pioneered by Britain, playing Sancho Panza to the US’s Don Quixote. It became the loyal servant, ready to provide less formidable military auxiliaries and financial support to US operations.
But in one crucial arena the Europeans have set out to be masters of their own destiny-in the decision to develop a single currency. Will Britain become part of it? The likelihood is that the pound will be merged into the euro by January 2002. As one of the big European economies and the most involved in global financial markets, its joining will be an asset for the euro and for the European project. It will also be an asset for the US: an implicit guarantee that the euro will not be manipulated against US interests, and that the Atlantic alliance of the cold war can endure into the geo-economic world of the future.