by C. Fred Bergsten, Peterson Institute for International Economics
Article reprinted from Foreign Affairs
(volume 78, number 2)
© 1999 by C. Fred Bergsten. All rights reserved.
The launch of the euro offers the prospect of a new bipolar international economic order that could replace America's hegemony since World War II. The global trading system has already been jointly run since the early days of the European Common Market, which enabled Europe to integrate its commerce and exercise power equivalent to that of the United States in that domain. Now Euroland will equal or exceed the United States on every key measure of economic strength and will speak increasingly with a single voice on a wide array of economic issues. The euro is likely to challenge the international financial dominance of the dollar. Moreover, the end of the Cold War has sharply reduced the importance of U.S. military might for Europe and pulled aside the security blanket that often allowed both sides to cover up or resolve their economic disputes for the greater good of preserving the anticommunist alliance.
Economic relations between the United States and the European Union will therefore rest increasingly on a foundation of virtual equality. The United States will either have to adjust to this new reality or conduct a series of rear-guard defensive actions that will be increasingly futile and costly — like the British did for many decades as their leadership role declined. The EU will either have to exercise positive leadership, which it now can do, or become highly frustrated at home and a spoiler abroad.
Partly as a result of these seismic shifts, transatlantic economic interdependence and joint responsibility for global leadership have grown rapidly for both economic superpowers. Europe and America therefore need to devise new strategies and institutional arrangements to manage both their bilateral economic relations and global economic issues. Such strategies can be constructed with or without a "common European foreign policy" that embraces traditional security issues; Europe itself has integrated far faster economically than it has politically. Japan will also be a partner in some elements of this collaboration. But until that country and the rest of Asia recover from their prolonged economic woes — which may take half a decade or more — transatlantic relations will be the crucial pivot for global as well as bilateral economic progress. And since Japan did not play a very forceful international role even prior to the Asian crisis, the timing or even the possibility of its full participation in the core leadership group remains highly uncertain.
The EU and the United States have yet to develop the required new approaches, however. Recent official discourse has focused instead on a range of narrow, highly technical, and even bureaucratic issues: bananas (which the United States as a country does not even directly export), testing procedures for pharmaceuticals, the appropriate representation of Euroland, which international committee should devise reform of the global financial system, and many other relatively minor matters. At their December summit, the two superpowers could agree only to consider new winemaking standards. Although the two sides need to address disputes over lesser issues — which are inevitable given their high levels of trade, finance, and investment—the gulf between policy requirements and operating reality is enormous.
Meanwhile, a long list of serious challenges remains unresolved. America and Europe are at loggerheads over global warming and energy policy. Despite extensive efforts, they have not resolved the bitter dispute over the extraterritorial impact of American foreign policy sanctions and only narrowly averted a collision over antitrust policy in the Boeing-McDonnell Douglas case. While many countries are still reeling from the global financial turmoil, the two economic superpowers snipe at each other about how to share its adverse effects on their own economies and about their competing regional initiatives in other parts of the developing world.
Their greatest failure, however, lies with the looming problems at the heart of the transatlantic economic relationship. America's trade and current account deficits will probably hit $300 billion in 1999. Any slowdown in the U.S. economy could trigger strong protectionist pressure from industries of central importance to Europe, as is already occurring in steel. In addition, the huge U.S. trade deficit and the likely worldwide shifts of capital into the euro could push the euro up sharply against the dollar in the near future. In turn, a stronger euro would hurt Europe's competitive position and seriously exacerbate its unemployment problem, while the weaker dollar would push U.S. prices and interest rates upward, igniting additional tensions across the Atlantic.
The bilateral relationship is thus drifting dangerously toward crisis. In addition, the global superpowers are only partially confronting several key systemic questions. On the monetary side, America and Europe, along with several key Asian countries, seem to be moving toward modest reforms in the "international financial architecture" to incorporate greater transparency in markets, more rigorous adherence to global financial norms, and modest improvements in International Monetary Fund (IMF) procedures. But the two superpowers have failed to propose, let alone implement, fundamental solutions to the unfolding financial crisis that could stabilize capital flows and the international monetary system.
There is little if any discussion of the momentous changes presaged by the creation of the euro — the biggest change in global finance since the dollar surpassed sterling to become the world's leading currency in the interwar period. There has been no U.S. willingness to even discuss Germany's proposals, now endorsed by the other key continental Europeans and Japan, to avoid the destabilizing currency gyrations that have been so disruptive over the past quarter-century. On trade matters, the EU has proposed a Millennium Round of negotiations at the World Trade Organization (WTO) to open markets further and improve the global trading system, while the United States will host the next WTO ministerial meeting later this year to plan international trade policy for the early 21st century. Until quite recently, however, the United States had resisted the European initiatives and has still offered no detailed proposals of its own. In short, there is no meeting of the minds on how to proceed on either trade or money.
Furthermore, the two sides have not worked out any strategy to respond to the politically potent backlash against globalization already observed around the world, including on both sides of the Atlantic. That resentment could severely impede progress on key specific issues, as Congress has already demonstrated with its refusal to authorize new trade negotiations and its reluctant support for the IMF. The result could be a gradual undoing of the international economic liberalization of the past two or three decades and a profound alteration in policy around the world.
Economic relations between America and Europe are approaching paralysis just when a daunting policy agenda and the advent of full bipolarity require new cooperative initiatives. Officials devote enormous attention to minutiae but none to common strategy or the requisite institutional mechanisms for tackling a growing number of acute challenges. They react on an ad hoc basis to virtually every problem that arises while failing to anticipate readily foreseeable obstacles. To be sure, extensive trade and investment ties limit the probability of the kind of blowups that the United States and Japan have experienced, and transatlantic diplomacy is skilled at keeping problems under wraps. But the economies of America and Europe, not to mention transatlantic relations and the world economy, remain at considerable risk.
The Trade Dimension
The United States is entering its eighth year of economic expansion. The economy is at full employment. Price inflation is nowhere to be seen. The underlying competitiveness of most American companies is strong. The government budget is in surplus. Although the trade deficit is soaring to record levels, much of this is due to America's superior growth and the Asian crisis; the dollar is not nearly as overvalued as in the mid-1980s.
For these reasons it is particularly worrisome that American trade policy has been stalemated for four years. Despite the strength of the economy, opponents of globalization have successfully stymied any new trade negotiating authority since Congress approved the North American Free Trade Agreement (NAFTA) in 1993 and the Uruguay Round and WTO, which stemmed from the General Agreement on Tariffs and Trade (GATT), in 1994. Congress came close to blocking new U.S. contributions to the IMF — an imperfect but agreed instrument for responding to the global financial crisis that was sweeping the globe.
We know from history that trade policy tends to backslide toward protectionism unless liberalization continues moving forward. Fortunately, multilateral agreements in several key sectors — telecommunications services, information technology, and financial services — followed the Uruguay Round and maintained momentum for several years. (The United States was able to participate on the basis of residual authority from earlier legislation.) Since the failure of the Asia Pacific Economic Cooperation (APEC) forum's sectoral initiative and the flagging talks of the Free Trade Area of the Americas in 1998, however, no significant trade liberalization is under way anywhere in the world. Not surprisingly, the U.S. steel industry has entered the vacuum to seek widespread relief. Top administration officials expect a number of aggrieved bedfellows to follow shortly: machine tools, semiconductors, shipbuilding, textiles and apparel, some agricultural sectors, and perhaps others.
America's bipartisan trade policy of the past 65 years is at risk. This is especially true with a weakened administration that openly acknowledges a huge debt to organized labor for its surprise November 1998 "victory" and shrinks from reopening NAFTA-style splits within the Democratic Party as it eyes the elections in 2000. Even a modest slowdown in economic growth with small upticks in unemployment could tilt the balance toward protectionism. A relapse into recession could unleash substantial restrictive actions and even legislation.
This prospect threatens transatlantic relations for two reasons. First, many of the imports in question are from Europe itself: machine tools from Germany, sweaters and other woolens from Italy and the United Kingdom, and steel from throughout the region. Even U.S. restrictions on imports from other countries, such as steel from Russia or ships from South Korea, could inflame transatlantic relations if those restricted products are deflected toward European markets already hit by high unemployment and rising imports. The United States is already threatening to retaliate against European restrictions on banana imports and hormone-treated beef, while Europe is threatening to counteract those American steps as well as the U.S. sanctions on European companies operating in Iran and Libya.
Second, even the threat of American restrictions would seriously disrupt the "trade g-2" bilateral relationship between the United States and Europe that has managed global commercial policy for almost 40 years. Europe has spoken with a single voice on most trade matters since the creation of the original Common Market. Hence, it has been able to convert its status as the world's largest trading entity into effective negotiating equality with the United States on trade. The three major GATT liberalization initiatives — the Kennedy, Tokyo, and Uruguay Rounds — ultimately depended on agreements between Europe and America. The more recent sectoral agreements also hinged on their cooperation. A policy reversal by the United States now, or even its failure to overcome the recent stalemate, would undermine the partnership that has been so vital to both regions and to the world trading system.
To its great credit, the EU has recognized the pending threat and proposed a new "Millennium Round" to improve and expand the WTO system, restarting the liberalization process and strengthening the multilateral framework. Such a negotiation would include sectors, notably agriculture and services, that would greatly expand American exports. Indeed, the United States and the EU share an interest in moving as far as possible toward global free trade. They have already eliminated most of their own import barriers, so such an initiative would require the rest of the world to catch up with them, expanding their exports and creating high-paying jobs. The administration failed to endorse the EU strategy until very recently, however, and has still made no specific proposals of its own, despite its role as host of the next WTO ministerial meeting in late 1999. It has failed to convey to Congress or to the American public the huge opportunities for expanding U.S. exports, thereby undercutting the effort to win approval for any new negotiations.
Both sides now run the risk of drift and even paralysis in transatlantic trade policy — with potentially severe repercussions for the rest of the world. A slide into protectionism or even a failure to continue opening new markets would have a major impact on the global trading system. Could we then expect Asian economies, who depend on expanded exports to emerge from their deep recessions, to keep their own markets open? Would the transition economies in the former Soviet Union, Eastern Europe, and Asia stick to their liberalization strategies? With the backlash against globalization already evident everywhere, the ominous inward-looking protectionist and nationalistic policies that the world has rejected so decisively could reemerge once again.
A failure of transatlantic leadership would make such policy reversals particularly likely. The United States and the EU are the only economic superpowers and the only two regions enjoying reasonable economic growth. They created the GATT system and, more recently, the WTO. Despite their own occasional transgressions, they have nurtured and defended the system throughout its evolution over the past 50 years. While Japan has been important on a few issues and the developing countries played an encouraging role in the Uruguay Round, the Atlantic powers built and sustained the world trade order. Their failure to maintain that commitment would devastate the entire regime.
Whither the Dollar?
Although the transatlantic partnership in trade looks shaky, the financial dimension could prove even more disruptive as the euro becomes a major global currency. The euro now represents an economy almost as large as the United States and will be even larger when all 15 EU countries become members. It enjoys considerably larger trade flows and monetary reserves and can boast a far stronger external financial position as a sizable creditor area; in contrast, America's net foreign debt now approaches $2 trillion. As soon as the European Central Bank establishes its credibility, the euro will become a global financial asset and produce a portfolio diversification from dollars into euros by private investors and central banks that could ultimately reach $500 billion to $1 trillion.
The short-term problem is that the shift from dollars to euros could lead to a broad swing in the dollar-euro exchange rate. America's huge trade deficits are certain to produce a sharp fall in the dollar soon anyway, as they have done about once per decade since the early 1970s. The dollar fell 25 percent against the yen during the second half of 1998, and large dollar-yen swings have often preceded general gyrations in the dollar. Europe's unusually large trade surplus, by far its greatest since the mid-1980s, suggests that part of the dollar's decline will be against the euro. The portfolio shift into the euro could trigger this event and amplify the dollar's decline, already expected on the heels of America's trade deficit. Some European experts have predicted that the euro could rise by as much as 40 percent against the dollar. This is far more than the 10 percent or so that underlying economic conditions suggest but nonetheless is plausible, since currency markets often substantially overshoot their long-run equilibrium levels.
An excessive appreciation of the euro would hurt European competitiveness and push Europe's unemployment up at a time when the new governments throughout the region are determined to get it down. French officials and German industrialists are in fact loath to contemplate any further decline of the dollar, and some even believe that the dollar is now undervalued. Although they will have to accept some fall in the dollar to help correct America's excessive trade deficit and ease U.S. protectionist pressures, the exchange rate could again become another highly contentious issue across the Atlantic.
America obviously needs a currency correction to help reduce its trade deficit. In light of the lag between exchange-rate shifts and trade flows, the administration must hope that it will come sooner rather than later so that results, especially for industrial workers, show before the 2000 election. But a sharp general fall in the dollar could trigger latent inflationary pressures as long as the U.S. labor market remains tight. In turn, the dollar's decline could push up interest rates on inflation fears and foreign demand for higher returns in a falling currency. The stock market could drop and the impending slowdown could even tilt into recession. In short, the result could be an abrupt termination of America's "economic miracle."
The official American position states that the creation of the euro "is good for America if it is good for Europe." This is correct but banal, given the strong impact that the euro could have on the fundamental economic variables on both sides of the Atlantic. At a minimum, the two sides need to agree on a dollar-euro range that would reflect their respective domestic economic conditions. They should then devise new mechanisms, such as clear policy statements and direct intervention in the markets, to keep the rate from straying too far from these underlying fundamentals.
Renewed transatlantic currency instability, and especially a corresponding increase in U.S. interest rates, would also be poisonous for Asian and other emerging market countries trying to recover from the current crisis. Higher American interest rates would increase the cost of servicing their largely dollar-denominated foreign debts and send much-needed capital flows to America instead of to their own needy economies. A failure to manage the dollar-euro relationship effectively could thus have severe consequences worldwide.
These examples only begin to reveal the impact of the new monetary conditions on the United States and the world economy. The existence of a real competitor to the dollar means that the United States will have to pay higher interest rates to attract foreign capital to finance its large external deficits. Such competition will be healthy for the United States over the longer run by providing an incentive to avoid huge budget deficits and double-digit inflation; it might even eventually eliminate its trade imbalance. But the new competition could be quite uncomfortable for a while.
The new monetary environment will also substantially affect the world economy. The dollar and the euro will probably account for roughly equal shares of the great bulk of international financial assets. Prolonged misalignment between them will generate similarly skewed results for other countries that peg their units to either currency. Indeed, the dollar's sharp rise against the yen from 1995 to 1997 partially caused the Asian crisis, since most of the Asian currencies were effectively tied to the dollar. Moreover, misalignments among the major currencies contribute to disruptive protectionist pressures — with particularly large costs for developing and other heavily trade-dependent countries. In addition, considerable dollar-euro instability is likely even without prolonged misalignment because both superpowers will be continental economies with only a modest reliance on trade. Europe may be tempted to emulate America's periodic "benign neglect" of the exchange rate, especially given the European Central Bank's mandate to focus on price stability — but at the cost of hurting smaller countries more sensitive to instability.
As with trade, the two partners bear enormous responsibility for the global monetary system. Despite the high stakes, however, there is still no evidence of serious discussion, let alone strategic preparation or contingency planning against the risks outlined above. Why is there such a gap between the challenges of economic policy and the apparent responses of the United States and the EU? There is certainly no dearth of meetings. The leaders hold semiannual summits and lower-level officials get together constantly. The governments have been quite adept at declaring the launch of new transatlantic "dialogues," "partnerships," and "marketplaces," but the fundamental problems remain unresolved.
Closing the Gap
There is plenty of blame to go around for this lack of preparation. Europe has been preoccupied with regional initiatives, most notably with the euro but also with its enlargement of membership and reordering of regional finances.Its relentless expansion of trade association agreements now encompasses more than 80 countries and raises doubts about its commitment to nondiscriminatory multilateralism (despite its proposal for a Millennium Round). It has failed to design effective procedures to represent Euroland in international financial councils, with member states jealously defending their national prerogatives. This approach has frustrated Americans (and others) who had anticipated more streamlined decision-making. To paraphrase Henry Kissinger, the United States still does not know who to call in Europe when new crises hit. Europe's failure to effectively tackle foreign policy problems in its own backyard, notably Bosnia and now Kosovo, has invited disrespect and even ridicule over the prospect of real partnership.
As I noted above, however, the Europeans have begun to address the transatlantic and global agendas, such as proposing a Millennium Round to restart the trade momentum. They have also floated suggestions for improved exchange-rate management that could reduce the risks of misalignments and instability. Although detailed blueprints for implementing these ideas have yet to be laid out and caution still prevails, the Europeans have nevertheless tried to launch the process.
For its part, the United States has contributed to the lag in two key ways. First, the domestic backlash against globalization adversely affects relations with Europe and the rest of the world. Given its concern for lower-income Americans and the disruptions generated by rapid technological change, the administration has been curiously ineffective in improving the domestic adjustment programs and safety nets that could buffer trade-induced job insecurity and downward pressure on wages. It has failed to work out credible international initiatives on labor standards and environmental concerns, and neither the Republican-led Congress nor the business community has demonstrated the necessary flexibility to foster a political consensus on those key topics. Instead, the administration has mostly backtracked in the face of resistance rather than mounting an effective response, thereby undermining the prospects for tackling the economic challenges ahead. In short, it has failed to reestablish a political foundation for a sustainable foreign economic policy. Europe can understandably view the United States as inward-looking, just as Americans can level that charge at Europeans.
Second, the United States suffers from schizophrenia on the international front. On the one hand, it claims that Europe (and, during better times, Japan) should assert greater international responsibility and "share the burdens of leadership." On the other hand, its revealed preference is to try to maintain American dominance—even while asking others to pay the bill—and to exploit national differences within Europe whenever possible. (The Europeans are also no strangers to this; they continually talk of "a common foreign policy" but almost always act nationally.) One senses that some American officials resist European or other international ideas simply because they originated elsewhere. Whatever the cause, the administration has responded with studied indifference or outright hostility to constructive European trade and monetary proposals.
Regrettably, the Clinton administration has not replied to these European suggestions with any strategic visions of its own. Instead, it has reacted rather than led, whether the challenge was international (like the Asian financial crisis) or domestic (like the antiglobalization campaign). Such a lack of initiative, or even a thoughtful response, costs the United States dearly when confronting major developments such as the advent of a new economic superpower and a challenger currency. Even beleaguered Japan has endorsed Europe's calls for a Millennium Round and new approaches to currency management. The United States must realize that it will be outflanked on economic issues by the other two industrial giants if it continues its passivity.
An important part of the problem is bureaucratic buck-passing. Even though they eventually intervene when forced by events, monetary authorities on both sides of the Atlantic like "freely flexible" exchange rates because they can then blame currency problems on "the market" rather than themselves. Central banks in particular resist any policy framework that might place even the most limited constraints on their cherished independence. Moreover, neither America nor Europe is good at managing the interaction between monetary and trade issues—with different ministries in charge of each domain and little coordination between them—despite the obvious economic linkage.
It will not be easy to convert the current transatlantic malaise into an effective partnership. The United States faces significant domestic constraints, both economic and political, and Europe has a full "domestic" agenda. Governments always find it hard to take forceful preventive actions. The turf problems described above represent formidable practical barriers. So what can be done?
There is no need for new transatlantic "grand designs." Instead, the EU and the United States need to install effective working arrangements to address the serious problems ahead, both in their bilateral relations and in the joint challenges of global leadership that will become even more difficult in the coming months and years. They should take separate approaches to financial and trade issues.
The immediate goal on the monetary front is modest: to keep the dollar-euro exchange rate from straying so far from underlying economic fundamentals that it damages their economies, the transatlantic relationship, and the global system. America and Europe should retain flexible exchange rates as the basic paradigm but plan their management preemptively rather than deploying ad hoc measures too late, as at present. Monetary authorities could agree on a fairly wide range, perhaps 10 to 15 percent on either side of an agreed midpoint of 1 1.00 = $1.25-$1.30, that would limit dollar-euro fluctuations. Such a band includes the startup rate of 1 1.00 = $1.17 but prevents any significant dollar appreciation from that point or any dollar depreciation beyond its previous lows against the constituent European currencies. The authorities should announce their agreed range to convey clearly their official intention to the markets. A qualified majority vote of the EU Council of Economic and Finance Ministers could endorse such an incremental alteration in managing floating rates, while any major reform (like a return to fixed Bretton Woods-style parities) would need its unanimous approval.
Despite their modesty, such new arrangements would provide a helpful operational focus for America and Europe to agree on appropriate exchange rates. They would require close monitoring of the markets and creation of an effective mechanism for joint intervention to protect the ranges. They would also encourage some policy coordination, including of monetary policy, when the exchange rate moves to the edge of the very wide band and something more than direct intervention and official statements is required. They would help stabilize private capital flows by indicating the limits of official tolerance of fluctuations; the absence of government guidance often encourages contagion and destabilizes capital flows when a currency comes under speculative siege. The relative stability of the two major currencies (or three currencies, when Japan reaches comparable agreements for the yen with America and Europe) would be enormously helpful for other countries, who could then peg their unit to one of the key currencies without running the risk of prolonged misalignments.
The scheme would be truly cooperative, based on initial proposals from Europe and Japan and worked out in detail with the United States. The outcome would be a concentric network of largely informal groups to manage international economic and monetary affairs: a core g-2 comprising the United States and Europe; a g-3 including Japan; the existing G-7, g-10, and g-22 to engage the next tier of key countries; and the global institutions, like the IMF, for formal implementation of the more far-reaching reforms. The involvement of the broader groups will ensure that the g-2 does not collude against the rest of the world and promote its own interests at everyone else's expense.
On trade, both sides must restart the process of global liberalization to counter the protectionist tide in the United States and the broader antiglobalization pressures everywhere. The United States and the EU should agree that the 1999 WTO ministerial meeting endorse the early launch of a Millennium Round. The negotiations should aim to produce tangible results every two or three years, to demonstrate progress and broaden market access in countries that still place large restraints on imports. They should also work out key issues of discord, including agriculture, competition policy, the implementation of the WTO rulings (which have been crucial in the banana case), and the rules governing regional arrangements. And they should address the environmental and labor issues that help drive the backlash against globalization.
On the institutional side, the g-2 relationship must be reinvigorated. It should again function as the core of the quadrilateral group with Japan and Canada, and then the full WTO itself. Such a strategy, along with more responsive U.S. domestic policies, should deflect enough protectionist pressure to get the two economic superpowers back on track in managing bilateral trade policy and their global responsibilities.
The Transatlantic Century?
Not too long ago, there was much debate over whether the next hundred years would be the "Japanese" or "Asian" century. Now, that looks less likely. The "European century" seems a more likely prospect, or even a "second American century." Some observers have suggested that the 21st century will have a "trilateral" focus on Europe, Japan, and the United States. But the most plausible candidate for economic success and global leadership may instead be the transatlantic partnership. If the United States and the EU can begin to cooperate now as equal partners, even in the economic arena alone, they could resuscitate the vitality of their own relationship and provide effective global leadership. If they fail to do so they will continue to drift apart like tectonic plates, with severe consequences both for themselves and for the world economy.
The economic integration of Europe over the past half-century, culminating in the euro, represents history's most dramatic success in institutionalizing interdependence. It has also been the most sensational instance of nations voluntarily relinquishing their sovereignty in favor of international collaboration. It has assured peace as well as prosperity through judicious economic amalgamation. The countries of the North Atlantic will probably never choose integration as deep as that of Europe and are unlikely to heed the call of former Secretary of State James A. Baker III to keep pace with Europe's course. But the completion of the European economic evolution provides the basis for an effective transatlantic partnership that could herald a similar, if more modest, success story over the next 50 years. It could also presage the next major step forward in managing the world economy.