American Interests and Europe's Monetary Union

The analysis presented here is based largely on the author's recent study, Cooperating with Europe's Monetary Union, Policy Analyses in International Economics No. 49 (Washington, D.C.: Institute for International Economics, 1997).

Economic and Monetary Union (EMU)—if it is achieved—will represent the most profound transformation of the international monetary system in a quarter century.¹ EMU will create a new monetary actor and a weightier bargaining partner than any the United States has dealt with in the postwar period. Without a doubt, EMU will usher in a new era in international monetary relations. What remains an open question, however, is whether this will be an era of cooperation or missed opportunities. I thus very much welcome the Committee's interest in Europe's monetary union and its potential impact on the United States.

My basic conclusion is that EMU is in the interest of the United States provided that several additional steps are taken.

Monetary union furthers U.S. interests in two fundamental ways. First, American firms and citizens will benefit from the reduction in transactions costs, consolidation of the single market and monetary stability in Europe just as Europeans will. Second, EMU will better enable 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. The presence of a robust and stabilizing European Union would help to ensure that new U.S. commitments under an enlarged NATO would not be tested. If the monetary union fails, on the other hand, the European Union would be weak and unsteady for years to come and thus not provide regional stability.

My provisos to the conclusion that EMU is in the U.S. interest are three. First, Europe must undertake further economic reforms to complement the monetary union. Second, Europe should undertake further institutional reforms to enable the monetary union to act as a coherent bargaining partner for the United States and to cooperate internationally. Third, while EMU may be in the broad geopolitical interest of the U.S., it will pose specific challenges to policymakers in the particular field of external monetary matters.

The presentation below addresses these matters in four sections on (1) specific policy issues that arise for the United States and the rest of the world during the transition to EMU; (2) institutional issues concerning European policymaking and international cooperation; (3) economic impact on the United States; and (4) the longer-term, structural impact of EMU on the role of the dollar, American policy options and international cooperation.

Policy Issues in the Transition

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 (Tables 1 and 2);

(b) induce a rebalancing of private investment portfolios from dollar-to euro-assets that could eventually amount to $400-$800 billion (Table 3);

(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.

Institutional Matters

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 policy with respect to the exchange rate between the dollar and the euro will be determined, for example, are only partially defined in the Maastricht treaty, however. Those arrangements are thus incomplete or problematic in three respects.

First, the 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. Ambiguity about representation in the making of informal accords, such as those typically struck in the finance G-7, is particularly troubling.

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.

The European Central Bank (ECB) is reasonably well defined and will be intimately involved in the making of most international monetary policies. But the ECB cannot and should not do this job alone.² 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.

Third, the treaty contains a strong bias against exchange rate stabilization and in favor of flexible rates.³ These provisions, unless modified, will effectively institutionalize the flexible-rate regime. Even those who favor the current regime of highly flexible rates might agree that it would be unwise to permanently foreswear greater currency stabilization.

Both foreign and European governments alike have been frustrated by European policymaking arrangements in the area of trade. The institutions, processes and distribution of competence for policy and negotiations are considerably less clear—by contrast—in the external monetary than in the trade realm.

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) remove the bias against exchange-rate stabilization in the Maastricht treaty, by shifting away from unanimous decisionmaking in the Council.

Robust institutions should be in place during the transition and before, rather than after, the next international monetary crisis. The United States and other countries must encourage European governments to take these decisions, which will be difficult. American officials, in particular, should insist on getting a clear answer to the question of who the Secretary of the Treasury telephones, or who telephones the Secretary, to resolve a crisis in the foreign exchange markets.

International forums and institutions 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 appropriate⁴- perhaps enlarged to include a representative of the EU to the extent that fiscal and financial-regulatory powers devolve to the Community.

Regarding the International Monetary Fund, the European member states should 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. (See Table 4). An amendment of the IMF Articles of Agreement might be necessary to accommodate this consolidation. 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 Fund⁵

Economic Impact

The impact on American interest rates and the value of the dollar is one of the most frequently asked questions about the effects of EMU on this side of the Atlantic. Economic science offers no definitive answer, unfortunately, because the impact depends on a host of other factors. Those include the success of economic reform within Europe, particularly the consolidation of the European capital market, and the mix of fiscal and monetary policies within the Union.

In order to reap the full benefits of monetary union, and thus spread growth rather than stagnation abroad, the European Union must further liberalize its economy. The labor market in particular must be liberalized in order to instill greater wage flexibility and worker mobility, thereby reducing the overall rate of unemployment. Deregulation, privatization and fiscal reform would also add flexibility to the economy. Without progress on this front, European growth would be sluggish and unemployment would remain high. The new monetary union could be tempted to compensate for weak domestic demand with greater external demand, resolving the unemployment problem through a low-valued currency or even trade protectionism. However, although the political commitment to undertaking this reforms now appears partial and halting, the completion of the monetary union would improve the chances of successful reform. Once the monetary union is consolidated, policymakers can more easily shift their attention and redirect their "political capital" toward this agenda.

Will a shift of private and official portfolios from dollar assets, including U.S. government securities, to euro assets increase American interest rates and reduce the value of the dollar? If the euro were to come to play a role equal to that of the dollar, a total of $950 billion could shift.⁶ Several caveats are in order, however. First, to achieve such status for the euro, the European Union would have to undertake more far-reaching development and integration of its capital market, which is not yet equal to the breadth, depth and liquidity of the American capital market (see Table 6). Second, a shift of this magnitude would represent roughly 7-8 percent of the domestic debt and equity outstanding in the United States - which would be absorbable if it occurred gradually over time, though prudent policymakers cannot assume that such a shift will be gradual. Third, and more importantly, these calculations address only the anticipated demand for dollar- and euro-denominated assets. An increase in the supply of euro assets, or a decrease in the supply of dollar assets, could well match the increase or decrease in demand for these assets. If so, the portfolio shift could occur with no change in American interest rates or exchange rates.

Another way of approaching the question of the impact on American interest rates and value of the dollar is to examine the impact of EMU on European savings and investment balances. Although the impact of monetary union on private savings and investment in Europe is likely to be small, its impact on public savings could well be much greater. The Maastricht treaty and the subsequent Stability and Growth Pact commit member states to moderate budget deficits and provide for sanctions against violators. Even if there is doubt about the effectiveness of these sanctions, national fiscal policies in Europe will clearly be more constrained under the monetary union than without it. This would tend to place downward pressure on European interest rates and consequently downward pressure on American interest rates as well.

Could tightness in the monetary policy of the ECB lead to higher U.S. interest rates or a lower dollar? The European Central Bank will indeed aggressively fight inflation, establish a reputation for price stability and raise interest rates if necessary to do so. The effects on the U.S. economy depend on the reaction of U.S. authorities. The Federal Reserve might match interest rate increases if it feared, for example, that a depreciation of the dollar would aggravate an incipient increase in domestic inflation. If domestic inflation is well under control, the Federal Reserve would probably forgo such increases, letting the dollar depreciate from the level that would otherwise obtain. Under the latter scenario, ECB policy would have little impact on American interest rates.

While the euro's impact on the level of exchange rates and American interest rates remains to be seen, an increase in currency volatility is quite likely during and probably 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, the future monetary policy of the ECB, the future path of 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 international and domestic 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.

Structural Change

Once all fifteen of the member states of the European Union join the monetary union, the euro area will have a GNP roughly fifteen percent and international trade roughly ten percent larger than the American economy (see table 7). The euro area will be similarly open to international trade - with exports and imports of goods and services amounting to roughly 23-24 percent of GNP (see figure 1) - rather than substantially more open as the individual European states have been during most of the postwar period. The euro will thus be backed by an economy that is larger and more powerful than any the United States has confronted, which raises important questions about the impact on the international role of the dollar, potential constraints on American policy choice, and international cooperation.

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. (Table 8) 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. (Table 9) 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 if the European Union liberalizes and integrates its capital market, the euro will begin to displace the dollar in these roles. The euro will certainly not replace the dollar as an international currency. At most, the euro might come to play a role that is equal to that of the dollar - primarily because the dollar has the advantage of already being broadly used and European capital market integration is somewhat uncertain. 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 run substantial federal budget deficits and to continue to run large current account deficits under normal circumstances.

Again, however, several caveats apply. 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, specifically, could cause substantially greater portfolio diversification out of dollar assets. Thus, although the future of the dollar remains mostly in the hands of American authorities, their range of policy options might well 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.

Third, financial reform and liberalization in Japan could compound the effect of EMU on the magnify the diminution in the role of the dollar. The international role of the yen has been constrained by the fragility of the Japanese banking and financial system. If the Japanese government's reforms of the financial system and capital market prove to be thorough and fundamental, the Japanese currency could become considerably more attractive and thus, combined with the effects of enhanced competition from the euro, have a more profound impact on the role of the dollar. American authorities are thus right to be calm but should not be complacent about the introduction of the euro.

Cooperation between the United States and Europe will be even more important to the international monetary system in the future than in previous decades. They will be the largest economies and traders in the world. The bilateral exchange rate between the dollar and the euro will be the world's most important and these currencies will be the most widely used internationally. At a minimum, U.S. and European authorities must avoid direct competition over the international use of these currencies and leave that to the private markets.

At the same time, however, U.S. and European authorities might well be tempted to adopt "mutual benign neglect" of one another's exchange rate, balance of payments and macroeconomic policies. With international trade representing a lesser portion of GNP than for individual European countries, the monetary union might wish to enjoy its greater insulation from currency fluctuation. Anxious to fend off any constraint on internal monetary policy, the European Central Bank will be predisposed against exchange rate stabilization. With U.S.-EU bilateral trade representing less than 20 percent of total U.S. trade, the United States will probably not be responsive to proposals for policy adjustments coming from Europe. For these reasons, strengthening domestic and international institutions will be vital to sustaining international monetary cooperation in the years to come. This task should be embraced with vigor and without delay by the European Union, United States and international community.

1 This presentation will assume, for the sake of contingency planning, that the monetary union will start on time and encompass a fairly large subset of the EU membership. Timely completion of monetary union is not inevitable, but is at this point sufficiently probable to require serious analysis of its global impact.

2 The ECB cannot simply assume by default all external monetary matters that are not explicitly delegated to others in the treaty because: (1) while the ECB clearly has operational authority, the Council of Ministers ultimately retains broad political authority for external monetary policy; (2) the involvement of political authorities is indispensable for a broad range of contingencies, such as a financial crisis in a Central or Eastern European country or a Plaza- or Louvre-type accord; and (3) external representation must be the product of a deliberate decision by the EU.

3 The fact that the treaty gives priority to domestic price stability over exchange rate stability is not the main problem—because currency stabilization within wide bands around equilibrium exchange rates should not conflict with domestic stability. The bias toward flexible rates is the cumulative effect of other features of the treaty. Specifically: (1) the risk that the ECB could use a perceived threat to domestic stability as a pretext for rejecting currency stabilization; (2) the absence of an official with designated authority to negotiate international agreements; and (3) the requirement that such agreements, if they are formal, have unanimous support within the Council of Ministers.

4 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.

5 These include the roles of the ECB versus national central banks in the monetary union's dealings with the IMF; the reconfiguration of the constituencies within the Executive Board (see Table 5); 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 recently agreed New Arrangements to Borrow (NAB). Questions such as these also confront many of the other international organizations to which EU member states belong.

6 Based on data for 1995 and excluding possible shifts of U.S., Japanese and European official reserves.

Table 1: EU international reserves, 1995 (in billions of US dollars)

Table 2: EU foreign exchange reserve ratios, 1995

Table 3: Estimates of private portfolio rebalancing

US
dollars Euro Other Estimated new share
if euro closes half
the gap^f 45.5 32.5 22 Shift from dollar to euro assets needed for this scenario = 397. Estimated new share
if euro achieves a role
equal to that of the
dollar^f 39 39 22 Shift from dollar to euro assets needed for this scenario = 795.
a. End-1994 from OECD (1996, A56).
b. IMF (1996, A38).
c. BIS (1996, 3At, 4Bt, 4Dt, 11Bt, 3).
d. End-1994 from United Nations Conference on Trade and Development (1995, 7).
e. IMF (1996c, 32).
f. On the assumption that only dollar and euro are rebalanced; assets in other currencies remain unchanged.

Table as presented in Henning, C. Randall. 1997. Cooperating with Europe's Monetary Union. Washington, D.C.: Institute for International Economics.

Table 4: IMF member quotas (top 20 countries)

Note: Quotas are those in effect as of 15 August 1996.
a. EU core includes Austria, Belgium-Luxembourg, France, Germany, and the Netherlands.
b. EU 27 includes the EU 15 plus Bulgaria, Cyprus, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Romania, Slovak Republic, and Slovenia.
Sources: IMF Survey (1996) and IMF (1996).

Table as presented in Henning, C. Randall. 1997. Cooperating with Europe's Monetary Union. Washington, D.C.: Institute for International Economics.

Table 5: Constituencies in the IMF Executive Board (as of 15 August 1996)

1. United States
2. Germany
3. Japan
4. France
5. United Kingdom
6. Belgium, Austria, Belarus, Czech Republic, Hungary, Kazakstan, Luxembourg, Slovak Republic, Slovenia, Turkey
7. Netherlands, Armenia, Bulgaria, Croatia, Cyprus, Georgia, Israel, Macedonia, Moldova, Romania, Ukraine
8. Venezuela, Costa Rica, El Salvador, Guatemala, Honduras, Mexico, Nicaragua, Spain
9. Italy, Greece, Albania, Malta, Portugal, San Marino
10. Canada, Antigua and Barbuda, Bahamas, Barbados, Belize, Dominica, Grenada, Ireland, Jamaica, St.Kitts and Nevis, St.Lucia, St.Vincent and the Grenadines
11. Saudi Arabia
12. Sweden, Denmark, Estonia, Finland, Iceland, Latvia, Lithuania, Norway
13. Australia, Kiribati, Korea, Marshall Islands, Micronesia, Mongolia, New Zealand, Papua New Guinea, Philippines, Seychelles, Solomon Islands, Vanuato, Western Samoa
14. Egypt, Bahrain, Iraq, Jordan, Kuwait, Lebanon, Libya, Maldives, Oman, Qatar, Syria, United Arab Emirates, Yemen
15. Russia
16. Switzerland, Azerbaijan, Kyrgyzstan, Poland, Tajikistan, Turkmenistan, Uzbekistan
17. Indonesia, Cambodia, Fiji, Laos, Malaysia, Myanmar, Nepal, Singapore, Thailand, Tonga, Vietnam
18. Iran, Afghanistan, Algeria, Ghana, Morocco, Pakistan, Tunisia
19. India, Bangladesh, Bhutan, Sri Lanka
20. Brazil, Columbia, Dominican Republic, Ecuador, Guyana, Haiti, Panama, Suriname, Trinidad & Tobago
21. China
22. Swaziland, Angola, Botswana, Burundi, Eritrea, Ethiopia, Gambia, Kenya, Lesotho, Liberia, Malawi, Mozambique, Namibia, Nigeria, Sierra Leone, Tanzania, Uganda, Zambia, Zimbabwe
23. Argentina, Bolivia, Chile, Paraguay, Peru, Uruguay
24. Côte d'Ivoire, Benin, Burkina Faso, Cameroon, Cape Verde, Central African Republic, Chad, Comoros, Congo, Djibouti, Equatorial Guinea, Guinea, Guinea-Bissau, Madagascar, Mali, Mauritania, Mauritius, Niger, Rwanda, São Tomé and Principe, Senegal, Togo

Note: Executive directors are from the countries in italics. The countries in bold are members of the European Union.
Source: IMF Survey (September 1996).

Table as presented in Henning, C. Randall. 1997. Cooperating with Europe's Monetary Union. Washington, D.C.: Institute for International Economics

Table 6: Capital Market Indicators in the EU, Japan and United States, 1995 (billions of dollars)

Sources: BIS; IFC; IMF; and OECD.
1 Includes only France, Germany, Italy and the United Kingdom.
Derived from data presented in Bergsten, C. Fred. 1997. "The Impact of the Euro on Exchange Rates and International Policy Cooperation." in Paul R. Masson et al eds., EMU and the International Monetary System. Washington, D.C.: International Monetary Fund.

Table 7: Share of World Output and Trade, 1995 (in percent)

Sources: UNCTAD; World Bank; WTO.
1 Goods and services.
2 Excluding intra-EU trade.
3 Austria, Benelux, France and Germany.

Table as presented in Bergsten, C. Fred. 1997. "The Impact of the Euro on Exchange Rates and International Policy Cooperation." in Paul R. Masson et al eds., EMU and the International Monetary System. Washington, D.C.: International Monetary Fund.

Table 8: Currency shares of official foreign exchange holdings, 1982-95 (percentages)

a. ECUs issued against dollars are treated as dollars
Source: International Monetary Fund (1996).

Table as presented in Henning, C. Randall. 1997. Cooperating with Europe's Monetary Union. Washington, D.C.: Institute for International Economics.

Table 9: Currency shares of private external assets, 1982-95 (percentages)

a. 1982-84 and 1985-87 averages are based on end-year 1983 and 1986 exchange rates respectively. The remaining years are based on 1990 exchange rates.
Sources: Organization for Economic Co-operation and Development (1993, 1988, 1985) and Bank for International Settlements (1996).

Table as presented in Henning, C. Randall. 1997. Cooperating with Europe's Monetary Union. Washington, D.C.: Institute for International Economics.

Figure 1: EU, Japan, and US:trade in goods and services^a, 1960-94 (percentages of GDP in current prices)

a. Trade is measured as exports plus imports at current prices.
b. Trade in services is apportioned between extra- and intra-EU(15) trade in the same proportion as trade in goods. EU(15) excludes Germany prior to 1991.
Sources: IMF, International Financial Statistics, European Economy, No. 59; US Department of Commerce; IMF, Direction of Trade Statistics.

Figure as presented in Bergsten, Fred C. and Randall Henning. 1996. Global Economic leadership and the Group of Seven. Washington, D.C.: Institute for International Economics.