> Former Fed Gov Lawrence Lindsey, a
> fervent supply-sider, holds the Arthur F. Burns Chair in economics at the
> American Enterprise Institute, on the Euro.
March 08, 1999
Arranged marriage
By Lawrence B. Lindsey
After the briefest of honeymoons,
the euro soon began sinking
against the U.S. dollar in world
currency markets (see chart).
Many skeptics of the marriage of
the 11 Euroland currencies
thought the groom (the rock-hard
German mark) and the bride (la
belle franc Française) were
incompatible, especially since the
bride brought her weak sisters
(lira and peseta) into the
marriage. Even though the whole
family worked to make them
fiscally fit and attractive by the
wedding date, just one month
after the wedding the Italians
were put on notice that their
fiscal health was slipping.
Behind these problems lies a
tension common to most
currencies: a conflict between
central bankers and politicians.
The central bankers are seeking
a strong currency that can be a
global rival to the dollar. The
politicians need a weak currency
to prop up their sinking
economies. This conflict was
papered over with promises of
large and immediate efficiency
gains from the currency wedding.
The structural advantages of a
single currency are real enough.
But they take time to produce
their desired effects. Partly this
is due to the euro's prenuptial
agreement, the Maastricht
Treaty. There are no euro notes
in circulation and won't be for
another two years. So the
inefficiency of constantly
exchanging currencies lives on.
The other potential source of
currency-driven efficiency
gains—the emergence of a
continental capital market to rival
New York's—is not something
that can be created overnight.
Left-leaning governments with
double-digit unemployment rates
simply can't stand by and do
nothing. They are unwilling to
abandon their socialist principles
and their electoral bases by
cutting tax rates, making their
labor markets more flexible or
engaging in other supply-side
programs. Maastricht,
meanwhile, limits their ability to
use fiscal stimuli to reflate their
economies.
What's left? Monetary policy.
Pressure is building for easier
money. At 3%, the official
overnight euro rate might seem
quite low, especially compared
with America's 4.75% rate. The
claim is that still lower rates will
encourage investment. But in the
core of Europe, high wage costs
and social insurance taxes make
new investment uneconomic.
Monetary stimulus is unlikely to
work.
The more plausible, but
unspoken, hope is that lower
interest rates will reduce the
euro's exchange value vis-à-vis
the dollar. A weaker euro is one
way of cutting real wage and
benefit costs relative to global
competition without actually
asking workers to take a cut.
But success at making the euro a
global reserve currency requires
that the currency be trusted as a
store of value. To date, holders of
the euro have lost both interest
income and foreign exchange
value relative to holders of the
dollar. Political pressure for
interest-rate cuts only makes the
euro less plausible as something
that will hold its value, the more
so given the unlikeliness that the
U.S. Fed will further reduce
rates.
Europe's banking sector has
been severely weakened by
losses in Eastern Europe, Asia
and Latin America. It has also
failed to develop the technical
sophistication of American banks
at constantly monitoring the
market value of their assets and
liabilities. While American banks
poured their information
technology budgets into
mark-to-market accounting
during the past few years,
European banks had to invest
huge sums to handle conversion
to the euro, as well as the
multiyear necessity of keeping
their books in two currencies.
Bad start
The euro falls against the dollar.
The result is a lingering fear
among European bankers that
unanticipated losses might
appear LTCM-like to sink a big
bank or two. A mild credit crunch
is beginning to affect European
commercial lending. This makes
any economic revival more
difficult and means that any rate
cuts will work primarily through
the exchange rate, not on
domestic demand.
For the year ahead the European
Central Bank will probably target
the dollar/euro exchange rate,
creating a trading range between
$1.10 and $1.20 (the euro was
$1.12 on Feb. 16). Both central
bankers and politicians can live
with the euro priced between
these poles.
Longer term, the euro will almost
certainly become a soft currency.
Without the tax and labor market
reforms required to unleash
businesspeople's animal spirits,
the Euroland economies are
doomed to disappoint.
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