by C. Randall Henning, Peterson Institute for International Economics
Testimony before the Subcommittee on Domestic and International Monetary Policy
Committee on Banking and Financial Services
United States House of Representatives
April 18, 1998
The monetary union in Europe will profoundly affect the external relations of the United States. It will pose serious challenges to the United States and international community on both policy and institutional issues, ranging from the management of exchange rates to the organization of the International Monetary Fund. To prevent these problems from undermining transatlantic relations and international cooperation, U.S. and European officials should consult proactively with the oversight of the Congress. I thus applaud your holding these hearings.
Geopolitically, a successful Economic and Monetary Union (EMU) is in the interest of the United States. Monetary union will equip the European Union to extend economic and political stability to Central and Eastern Europe, a region in which the United States would otherwise be called upon to play a stronger role. A successful monetary union would also benefit U.S. firms and citizens economically, through the reduction in transaction costs and consolidation of the European single market. In the arena of international money and finance, nonetheless, EMU will pose important challenges to U.S. policymakers.
EMU will be the most far-reaching transformation of the international monetary system in at least a generation. Assuming the European Council decides this coming weekend to bring eleven member states into the monetary union, EMU will have a population (almost 300 million) significantly greater, a GDP only slightly smaller, and a share of world trade (just under 20 percent) roughly the same as the United States. If all fifteen EU member states join, the GDP of the monetary union will be fifteen percent larger than that of the U.S.
The U.S.-EU trade and investment relationship will be the most important to the international economy. The United States and the monetary union, along with Japan, will have by far the largest current account imbalances in the world. The exchange rate between the dollar and Europe's new currency, the "euro," will be the single most important currency relationship in the international monetary system. The euro will instantly become the second most important international currency and, for the first time in the postwar period, the U.S. dollar will confront a robust alternative.
The sections below elaborate on (1) the determinants of the dollar-euro exchange rate, (2) the future roles of the dollar and euro as international currencies, (3) specific policy problems, and (4) institutional issues that require attention.
Dollar-Euro Exchange Rate
The euro area will tend toward a policy of "benign neglect" of the exchange rate between the dollar and euro. The openness of the monetary union, as measured by exports plus imports as a percentage of GDP, will be considerably smaller than the openness of the individual member states. For the EU11, trade in goods and services amounts to 29 percent of GDP, which would fall to about 25 percent if Britain joins. (This compares to U.S. openness of about 23 percent. See Table 1.) The monetary union will be able to tolerate substantial changes in the exchange rate with less economic disruption that experienced by individual member states. The European Central Bank (ECB), moreover, will target monetary policy toward price stability rather than the exchange rate.
The dollar-euro rate, which we cannot forecast with confidence at this point, will thus be the product of four main factors: monetary policy, fiscal policy, portfolio shift and current account balances.
First, the European Central Bank will be the most independent central bank in the world and will fight inflation vigorously, which will tend to put upward pressure on the euro against the dollar. But the ECB will also inherit a European economy with the lowest rate of inflation in three decades and will not be forced to raise interest rates on this account at the outset of the monetary union.
Second, the member states of the European Union have reduced budget deficits impressively over the last few years. They are committed under the fiscal rules of the monetary union to tightening fiscal policy further. Fulfilling that commitment would tend to place downward pressure on the euro against the dollar; breaking that commitment would tend to place upward pressure on the euro.
Third, the rebalancing of private investment portfolios from dollar-denominated assets to euro-denominated assets, which could be very large (see below), will also affect the exchange rate. But the magnitude and direction of this effect will depend on the amount of capital reinvested, the speed at which the reallocation takes place, and the supply of euro assets available in the market.
Finally, the European currencies are valued substantially less than the average rate against the dollar in the mid-1990s. The large and growing current account surpluses of the EU11 and deficits of the United States reflect the valuation of the currencies. These imbalances, plus the tendency of exchanges to revert toward the mean, will favor the euro against the dollar at the outset.
While the euro's impact on exchange rates remains to be seen, an increase in currency volatility is quite likely, both during and beyond the transition. Investors and portfolio managers will be confronting unusually high uncertainty during the transition to and early years of monetary union with regard to the speed of entry of those countries still outside the monetary union, particularly Britain; the future paths of monetary and fiscal policy within the monetary union; the supply of euro assets; and the development of the European capital market. Market assessments of asset value, risk and forecasts can be expected to be particularly weakly held and subject to change with news, that is, fickle. As a consequence, portfolio rebalancing could be erratic and "lumpy"—rather than continuous and smooth—and even subject to temporary reversals, creating instability in the foreign exchange markets.
Prudence counsels that governments and central banks take this prospect seriously. Greater volatility places a premium on their cooperating internationally, providing continuity and declaring their policy intentions in advance.
Roles of the Dollar and Euro
Consider next the impact of the euro on the international role of the dollar. Since the Second World War, the dollar has been more important than any other single currency as a store of value, medium of exchange and unit of account for official and private users. As of the end of 1995, the dollar comprised 61.5 percent of official foreign exchange reserves held by central banks around the world. In the same year, the dollar was the currency of denomination of 76.8 percent of international bank loans, 39.5 percent of international bond issues and 44.3 percent of eurocurrency deposits. In 1992, the dollar served as the invoicing currency for 47.6 percent of world trade and, in 1995, was one of the two currencies in 83 percent of foreign exchange transactions. Eliminating intra-European transactions from these figures, as is appropriate when analyzing the post-EMU environment, increases the relative role of the dollar substantially.
The role of the dollar thus remains considerably larger than the economic size of the United States and its importance in international trade; while the roles of other currencies have remained considerably smaller than their countries' shares of world trade and GNP. But as the United States and euro area approach rough parity in economic size and weight in world trade, the euro will tend to displace the dollar in these roles.
The speed and extent of that displacement depends largely on the progress of the European Union toward liberalization and integration of its capital market, which will determine the attractiveness of the euro for international investors. The total capitalization of the stock and bond markets of the EU11 is roughly half of that for the United States. (See Table 2.) The figure for the EU15 would be roughly two-thirds that for the United States. The European Union therefore has considerable distance to travel before European capital markets are as large, diverse and liquid as American capital markets. This will require the harmonization of tax, regulatory and accounting standards, among other things, which will take time.
The euro will certainly not replace the dollar. At most, the euro might come to play a role that is equal to that of the dollar over time. Dollar assets will therefore constitute at least 40 percent of all international financial assets for a long time to come. Private and official investors around the world will continue to accept dollar assets in quantities that will permit the United States to continue to run large current account deficits under normal circumstances.
Two important caveats apply, however. First, the emergence of a more robust alternative to the dollar will make the international environment less forgiving of American policy mistakes, such as the over-expansionary monetary policy in the 1970s and the over-expansionary fiscal policy in the 1980s. American policy errors could cause substantially greater portfolio diversification out of dollar assets than they did in the past. Although the future of the dollar remains mostly in the hands of American authorities, therefore, their range of policy options will be narrower than in the past.
Second, circumstances will not always be normal. Consider the year 1987, when at least two-thirds of the huge U.S. current account deficit was financed not by the private markets but by foreign central banks. When private capital flows into the United States dry up in the future as they did then, European authorities, less vulnerable to appreciation of their currency than they were in the 1980s, will have weaker incentives to buy dollars. If they chose to do so, European officials might insist on American policy adjustments as a quid pro quo. American authorities are thus right to be calm, but should not be complacent about the introduction of the euro.
Specific Policy Issues
Monetary Union in Europe will raise a number of specific policy matters for the United States that deserve more attention than they have received to date in the public discussion. EMU will very likely:
(a) create excess dollar reserves in the hands of European central banks that could eventually amount to $50-100 billion;
(b) induce a rebalancing of private investment portfolios from dollar- to euro-assets that could eventually amount to $400-$800 billion;
(c) provoke greater exchange rate instability during the transition, with the risk of sustained currency misalignments;
(d) have consequences for the international system arising from the relationship between the euro and the currencies of the member states that do not join the monetary union, the so-called ERM2 arrangement;
(e) divert the attention of European officials from global concerns to the successful completion of the monetary union.
American and European monetary authorities should consult on these matters bilaterally and within the international forums such as the meetings of finance ministers and central bank governors of the Group of Seven countries—the "finance G-7"—and International Monetary Fund.1 Their ability to do so successfully, however, will depend on addressing several institutional problems.
EMU raises questions about the institutions of both European policy making and international finance. Consider first the European institutions and processes of external monetary policymaking. The United States and the rest of the world have a strong interest in a European Union in which decisionmaking is transparent, institutional competence is clear, coordination occurs internally, and common positions are reached with reasonable efficiency. The institutional arrangements by which the external monetary policy of the euro area will be determined, however, fall short of this standard.
First, the Maastricht treaty leaves up in the air the question of how the EU is to negotiate international monetary agreements and who will represent the monetary union in international organizations. Recent discussions among Europeans have been useful but have not sufficiently clarified these matters. Second, the treaty does not specify who within the monetary union will be responsible for international cooperation in managing financial and currency crises and what latitude they will have in reaching emergency agreements with non-European governments and central banks.2 The European Union must identify which official (or officials) will serve as the counterpart to the Secretary of the Treasury. Who does the Secretary telephone, or who telephones the Secretary, to resolve a crisis in the foreign exchange markets?
I recommend that the European Union (1) identify an official on the political side to speak for the euro area in international monetary negotiations; (2) give this official an open mandate to negotiate agreements, both formal and informal ones, with other political authorities as circumstances (such as a Mexican- or Asian-style currency crisis) require; (3) agree in advance within the Council of Ministers to procedures for quickly ratifying (or rejecting) any international agreement that this official negotiates; and (4) move away from unanimous decisionmaking and toward qualified majority voting in the Council.
In the absence of coherence on the political side of external monetary policymaking in the monetary union, the U.S. Treasury might find itself reliant on the Federal Reserve to arrange solutions to foreign exchange crises with the European Central Bank. The institutional position of the Federal Reserve with respect to the Treasury would thereby be strengthened in the international field, with no deliberate decision having been taken to this effect. For this reason alone, the United States has an interest in raising these institutional questions with European governments.
Failure to address the matter of representation and negotiating authority would also reinforce the structural tendency of the monetary union toward neglect of the exchange rate. This institutional weakness would be particularly dangerous in a period of increased exchange rate volatility and, potentially, misalignments. The United States and other countries must encourage European governments to take these decisions, which will be difficult.
Consider next the international forums and institutions that must also be modified to take account of the formation of the monetary union. A "monetary G-3" should be created from the present finance G-7 to discuss exchange rate and monetary matters among the United States, Japan and the monetary union. The EU monetary representative from the political side that is proposed above should attend meetings of the monetary G-3 along with the president of the European Central Bank. For matters ranging beyond exchange rate management and monetary policy, however, the broader group of seven would still be appropriate3—perhaps enlarged to include a representative of the EU to the extent that fiscal and financial-regulatory powers devolve to the Community.
The national finance ministries and central banks of the European members of the G-7 will undoubtedly resist the consolidation of representation even for the discussion of monetary issues in a G-3. This position is not tenable in the long run for at least two reasons. First, the governors of the national central banks will be the rough equivalent of the presidents of the district reserve banks within the Federal Reserve System after the monetary union is formed. Including them in discussions of monetary and exchange rate cooperation makes no more sense than including the presidents of the federal reserve banks. Second, the member states of the monetary union are committed to adhering to a single external monetary policy and thus a single position in international forums. Singularity of policy will be difficult to reconcile with multiple finance ministers speaking for the euro area.
Regarding the International Monetary Fund, the European member states should also yield eventually to direct representation of the euro area in the IMF. A consolidation of the quotas of the European member states into one would reduce the overall European share of IMF quotas, freeing up quota shares for other, fast-growing regions of the world, which would contribute to better balance between economic size and influence within the organization. Consolidation would also rationalize the representation of Europe within the Executive Board. The eleven prospective members of the monetary union are now spread across eight "constituencies," groups of countries which aggregate their representation and which include many non-European countries. Adhering to the obligation to pursue a common external monetary policy while also compromising with the non-Europeans will be a difficult exercise, to say the least.
More immediately, the European Union, IMF staff and the rest of the membership of the IMF must resolve—and indeed are now consulting on—a number of practical issues that EMU will present to the Fund. These include the roles of the ECB versus national central banks in the monetary union's dealings with the IMF; the reconstitution of the Special Drawing Right (SDR); introduction of the euro into the operational budget of the Fund; the conduct of multilateral surveillance; and procedures for activation of the New Arrangements to Borrow (NAB) now before Congress.
Questions of representation and negotiating authority raise politically sensitive matters of bureaucratic prerogatives within the European Union. For that reason, many European officials would prefer to ignore or delay their consideration. The global economy may not permit the European Union to take its time in addressing these matters, however. Several emergency contingencies could well require a concerted international response over the next eighteen months: instability stemming from the formation of the monetary union; continuing effects of the Asian financial crisis; a new currency and/or financial crisis, perhaps in the neighborhood of the European Union, such as Central and Eastern Europe. The United States and European Union should have effectively operating institutional arrangements for cooperation before, rather than after, the next crisis strikes.
|Table 1: Openness of the European Union and United States 1|
|EU 11 plus the UK||24.0%||24.9%|
|Source: Calculated from International Monetary Fund, Direction of Trade Statistics Yearbook and International Financial Statistics.|
|1 Exports plus imports as a percentage of GDP (intra-EU trade excluded)|
Table 2: Capital Markets of the European Union and United States, 1995
(in billions of U.S. dollars)
|Stock Market Capitalization||Debt Securities||Debt and Equity
|EU 11 plus the UK||3,527||7,819||11,346|
|Source: International Monetary Fund. International Capital Markets.|
|Washington, D.C.: International Monetary Fund. November, 1997|
|1Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain.|
|2EU 11countries plus Denmark, Greece, Sweden, and the United Kingdom.|
1. In addition to these policy questions, there is a host of issues that concern American businesses with operations in Europe. Those range from the broad to the specific. Among the broad concerns is the macroeconomic stance of the euro area, whether it contains a deflationary bias and whether such a bias could contribute to political pressure for trade protectionism. Whether Europe successfully tackles a broad agenda of additional reforms to complement the monetary union—such as labor market reform, deregulation, privatization and fiscal consolidation—also affects how American companies do business in Europe. American financial firms will closely monitor the impact of the euro on the consolidation of European financial and capital markets, attentive to opportunities for market entry. The specific concerns of business include cash management during the transition to the euro, greater transparency in retail pricing within the euro area, the Ayear 2000" problem, and tax treatment of the conversion of corporate accounts in euro. Several of these issues have policy and regulatory ramifications.
2. The European Central Bank (ECB) will be intimately involved in the making of most international monetary policies. But the ECB cannot and should not do this job alone. The political side of international monetary policymaking, which would correspond to the Treasury Department in the United States, is underdeveloped and its working relationship with the ECB is very ambiguous. The Council of Ministers should assert its powers in this area and can do so without fundamentally compromising the independence of the ECB on domestic monetary policy.
3. Britain in particular could not be excluded from financial discussions—such as lender of last resort action, banking supervision and regulation, and money laundering—even if it were not part of the monetary union.