助成

Institute forInternational Policy Studies
・Tokyo・

IIPS International Conference“Enlargement and Future of Europe 2002”
Tokyo, 12-14 November“EMU between the Introduction of Euro Cash and EU Enlargement”
by
C. Randall Henning
American University and Institute for International Economics
Washington, D.C.
November 2002

EMU between the Introduction of Euro Cash and EU Enlargement1
by
C. Randall Henning
American University and Institute for International Economics
Washington, D.C.
November 2002

Introduction

The creation of the euro area at the beginning of 1999 was arguably the mostimportant change in the international monetary system since at least the shift from fixed
to flexible exchange rates in the early 1970s. The introduction of euro cash in early 2002,
which was remarkably smooth, further consolidated the monetary union. The
enlargement of the European Union to 25 member states in 2004 would set the stage for asimilar expansion of the euro area. The present, nearly four years after the formation of
the monetary union, is thus opportune for an examination of the impact of the euro on
Europe and international relations.
Because this conference addresses matters of politics as well as economics, myremarks will begin with some observations about security. I will then address mattersrelated to the internal management of the euro area, then the external relations of themonetary union.
Analyses of EMU during the 1990s contained some bold predictions andwarnings, some regrettable and some prescient. My candidate for the most regrettable is

1

Prepared for the conference “Enlargement and the Future of Europe 2002,” organizedby the Institute for International Policy Studies, Tokyo, November 12-14, 2002.

Martin Feldstein’s suggestion that monetary union and attempts to consolidate political
integration could lead to civil war in Europe. Although war was not inevitable, he wrote
in 1997, “it is too real a possibility to ignore when weighing the potential effects ofEMU.” Two years ago, he reiterated that the monetary union is still more likely toincrease conflict in Europe than cooperation. (Feldstein 1997 and 2000)
An opposing forecast was offered by Valery Giscard d’Estaing, the former
President of France and current president of the European Convention. He said that two
decades from now the euro will be such an accepted part of the European economic
landscape that people will look back on twentieth century and wonder with perplexity
why countries insisted on each retaining their individual little currencies for such a longtime.
Well, the first four years of the monetary union provide not a shred of evidence
that political disintegration and war are now more likely in Western Europe. This
forecast was completely misguided from the outset. The introduction of the euro in cash
form made it an even less likely prospect. Convergence within the euro area, though notcomplete, further buttresses this conclusion. (See, for example, Michael Artis’s paper forthis conference.) I expect the next several years to put Feldstein’s fear to rest. Giscard’s
forecast is far more likely to prove to be valid.
I also believe that the monetary union is very much in the interest of the UnitedStates, Japan, and the rest of the world and will be seen to be mutually beneficial
ultimately. However, there is, of course, still more work to do before arriving at thishappy outcome. (For a broad treatment of EMU and its impact on global monetary
governance, see, Andrews, Henning and Pauly 2002.)

Internal Matters
Monetary Policy
Prior to the monetary union, we saw predictions that monetary policy would, forvarious reasons, be too tight or too lax. We also heard some predictions that European
fiscal policy would be highly expansionary, that the ECB would be forced to tighten in
response, leading to the Reagan-Volcker policy mix, with undesirable consequences forexchange rate and balance-of-payments stability. Fortunately, during most of the earlyphase of the monetary union, fiscal and monetary authorities seemed to have understood
the logic of the interdependence between their policies, and pursued instead the ClintonGreenspan mix.
However, the easy relationship between monetary and fiscal policy during thefirst three years has given way to conflict between monetary and fiscal authorities. In theface of weak growth, fiscal deficits have been rising in the euro area, pressing or
exceeding the limits permitted under the Maastricht treaty and the Stability and Growth
Pact in some countries. Such deficits have made the European Central Bank somewhat
reluctant to ease monetary policy. Meanwhile the ECB’s stance -- which was stiffened
for a time by popular perceptions of price gouging after the introduction of notes andcoins – aggravates the fiscal dilemmas of member states.

Stability and Growth Pact
Conflict recently boiled over with the European Commission’s criticism of the
new French government’s budget plans announced in late September 2002, an Ecofin
vote against France, the German government’s admission that it will run an excessive
deficit this year and its pressure on the ECB to ease monetary policy. The president of
the European Commission called the Stability and Growth Pact “stupid.” (Economist,
October 26, 2002) Officials now openly speculate about revisions to the Stability and
Growth Pact. Several amendments have been proposed. The most prevalent proposal is
to make the structural deficit, not the actual deficit, the focus of national obligations.
Another is to define the commitment not in terms of a single year but over the mediumterm or business cycle. A third is to make allowance for member states with low levelsof debt relative to GDP. A fourth is to introduce the “golden rule,” allowing states toborrow the amounts that they invest in capital improvements without scoring themagainst their permitted deficit. A final proposal would incorporate unfunded pension
liabilities in calculations of fiscal sustainability.
I believe that changes to the SGP are desirable – to focus on cyclically-adjusted
deficits and thereby avoid pro-cyclical policy adjustments (such as Germany is now
embarked upon). That need not imply more laxity in the European fiscal regime as awhole. But it is admittedly difficult to redefine the rules when major countries are
exceeded the formal limit without creating the widespread impression that the rules arebeing made generally more permissive. Ideally, the redefinition of the regime shouldtake place at the peak, rather than the trough, of the business cycle. Instead, the euro area
is revising the Stability Pact at a decidedly inopportune moment. It can limit damage toits credibility by strengthening the monitoring and enforcement of the amended rules, as
the European Commission has proposed. Needless to say, this is a critical moment forthe credibility of the fiscal regime of the European Union.
Central Bank Independence
Much has been made of the independence of the ECB and the Eurosystem. Some(see, for example, Cooper 1992) have argued that it is excessive, while others (German
economists) have worried that it is insufficient. Beyond the autonomy provided by theMaastricht treaty, the institutional position of the ECB is closely connected totransparency and accountability; the roles of the national central banks relative to thecenter; the downsizing of staff in the system as a whole. (For discussion, see, Berman
and McNamara 1999; Meade 1999; Caporaso 2000.) Moreover, the ECB is affected by
the enlargement of the membership of the European Union and the broader reforms of the
EU institutions that might redress the democratic deficit, such as the reforms being
considered in the present European Convention.
Sometimes missing in the economic discussions (Lohmann is an exception) is anappreciation of the importance of a societal constituency for central-bank independence,
one that goes beyond the financial sector. Political analysts of European integration havea greater appreciation of this and have been writing about the democratic deficit faced by
the ECB as part of the broader democratic deficit of the EU and indeed part of thebroader concern about political legitimacy of international institutions in general.
It is important to stress that independence should not be confused with being
apolitical: central banks that remain independent over long periods of time are in fact
highly political and they actively cultivate a constituency for their autonomy. It is fairly

safe to say that the ECB would not be wise to rely exclusively and passively on its
protected status in EU law. The ECB will have to cultivate this constituency as adroitly
as the Federal Reserve and Deutsche Bundesbank have done. Its institutional andpolitical environment is considerably more complex and fluid -- with successiveintergovernmental conferences on institutional reform and enlargement of the EU. But
the introduction or euro notes and coins have given the ECB a direct relationship to
European citizens as the guarantor of the value of money in their pockets. This may be
one of the most significant consequences of the introduction of euro cash.
The experience of the Federal Reserve, the Bundesbank and now the European
Central Bank, and in particular the importance of actively cultivating societal support forautonomy, may hold particular lessons for the Bank of Japan as it addresses theformidable economic problems of Japan.

Endogenous Currency Area
Prior to the creation of the monetary union, we heard a great deal about whether
the euro area met the tests of the theory of optimal currency areas. Most of the normative
debate over EMU hinged on these tests. Opponents argued that fiscal policy was too
decentralized, real wages too rigid, and labor too immobile for the euro-12 to constitutean optimal area. Under these conditions, they argued, the monetary policy appropriate
for one country (Germany) might well be inappropriate for another (Ireland).
While largely conceding some of the OCA arguments, proponents of EMU argued
during the 1990s that monetary union would set in motion a set of policy reforms thatwould render the euro area optimal after the fact. This has come to be called the“Endogenous Currency Area Hypothesis.” (Frankel and Rose 1998; Padoan 2002; Kenen
2002) The validity of this hypothesis is a question on which the ultimate judgment on
EMU by the rest of the world could well hinge. Clinton administration officials argued
that further flexibility in European economies was needed in order to ensure thatmonetary union was good for Europe and the rest of the world.
Monetary union has spawned some further integration in European capital
markets, the money and bond markets in particular. But more needs to be done. Stockmarkets, banking and insurance remain too segmented on national lines. European-widestandards on accounting, corporate governance, mergers and acquisitions, bankruptcy,
financial supervision and capital requirements – among other things – are needed tocomplete the “internal financial market.” EMU has contributed to cross-bordercompetition and to deregulation; more needs to be done here too.
The stickiest and most important area is the labor market. Here the evidence isdecidedly mixed. Some countries have moved toward greater flexibility; others’ progresshas been disappointing. Two observations are in order. First, this is a (very) long-term
process; it would be premature to conclude that endogeneity is not sufficient. Second, theprocess of reform is not simply an economic one but fundamentally political. We willneed a decade for a definitive answer to the endogeneity thesis.

External Matters

The external relations of the euro area raise a number of intriguing questions.
Why has the euro been so weak against the dollar? Will it strengthen in the face of
unprecedented U.S. current account deficits? Will the euro eventually displace the dollar
as an international currency? How can the euro area better organize the making of its
external monetary policy and represent it to the outside world?
The most intriguing overarching question for me is: Will international monetary
cooperation improve or decline with the consolidation of the monetary union and its
eventual expansion to new members? On this point, analysts have been all over the map.
The dominant forecast of the mid-1990s among economists was one of “mutual benign
neglect.” A minority view was offered by the European Commission in a 1991 report,
One Market One Money. It argued that having a single dominant monetary power was
not in fact necessary for international monetary stability -- against the so-called“hegemonic stability thesis” of some political scientists -- and that creating a larger more
powerful partner in the euro area would actually improve macroeconomic bargaining
outcomes among the United States, Europe and Japan. This would be done, the reportargued, by constraining the United States to “good policy.” The experience of the first
four years suggests that mutual benign neglect is the more valid of the two predictions.
The U.S. official posture has been complacent. When asked whether he feared
the creation of the euro, former Treasury Secretary Lawrence H. Summers said, “the fateof the dollar is in our own hands.” This is basically true. But it is also true that theUnited States has made serious policy mistakes in the past – monetary policy in the 1970s

and fiscal policy in the 1980s – and could well commit such errors in the future. (Perhaps
the making of tax cuts permanent would be such an error now.) But any such futureerrors will confront a greatly changed international environment: there would now be aserious alternative currency to the U.S. dollar backed by a large internal market for goods
and capital.
The U.S. current account deficit has reached very high levels. Within the next
few years, the finance-ability of deficits of this size could be called into question. The“new economy” and impressive productivity gains kept the U.S. markets buoyant andcapital flowing in recent years. (Mann 1999) Uncertainty surrounding U.S. accounting
rules and corporate governance, any stalling of productivity improvements, or persistent
weakness in growth could reduce the attractiveness of U.S. assets. There is no guaranteethat the balance-of-payments adjustment will be smooth. In fact, given the dependenceof the United States on capital inflows, one could easily paint a fairly ominous scenario.
The year 1987 holds particular relevance for this scenario. Owing partly to thedepreciation of the dollar since the Plaza accord, private capital flows into the UnitedStates largely dried up in that year. The large current account deficit at that time wasinstead financed by European central banks and the Bank of Japan through foreignexchange intervention. America’s partners were willing to act in this way in order to stem
the appreciation of their own currencies, thus the reduction in their trade surpluses and,by extension, in their growth and employment.
If private capital inflows were to dry up in the next few years, as they did in 1987,
the United States would now be facing a monetary union rather than individual European
monetary authorities. The euro area would be less vulnerable to exchange-ratefluctuations than the individual European countries had been prior to the monetary
union’s creation. European authorities might not be forced into the breach. If they choose
to finance U.S. deficits, European officials might this time insist on U.S. policy
adjustments as a quid pro quo. The instances where the monetary union could impinge on
the choices of U.S. policymakers will almost certainly be rare, but they are more likely tooccur when the United States is running large current account deficits.
Under such circumstances, it would be important to have well-functioning
mechanisms for international consultation and a demonstrated capacity for moredeliberate and sustained joint action in the markets than manifest in the Autumn 2000
foreign exchange intervention – the only such episode since the inception of themonetary union, and a fiasco in terms of transatlantic coordination.
Much attention has been given to creating a “Mr. Euro,” a proposal that I
advocate and endorse. (Henning 1997; Everts 1999) But the identity of this person andthe title he/she holds is less important than giving this person – perhaps the eurogroupchairman – the mandate to negotiate agreements, both formal and informal, within the G7 and with other political authorities as circumstances (such as a major financial or
currency crisis) require. This official must do more than simply read from texts preparedin the Economic and Financial Committee and Ecofin, but negotiate flexibly withcounterparts. Moreover, Ecofin should agree in advance to procedures for quickly
ratifying (or rejecting) any agreement that the representative, in consultation with the
ECB and the commission, negotiates. The EU should not allow external monetarydecisions to be held hostage to consensus or unanimity, and should move toward greatertransparency on these as well as other matters. The European Convention currently

underway offers an opportunity for progress on these institutional matters. These
provisions would help to avoid the pattern of deadlocks overcome only by crises, as
witnessed in transatlantic trade negotiations, which would be particularly damaging in themonetary arena, where quick, decisive action on the part of policymakers is required
from time to time. (For elaboration of these arguments, see Henning 2000a and 2000b.)
For their part, U.S. officials must ensure that they are well coordinated internallyand avoid ambiguity, for example, over whether the Treasury or the White House-based
National Economic Council speaks on exchange rate matters. The same is of course true
for Japan and the United Kingdom, which, along with Canada, constitute the remainderof the G-7 countries.
In this environment, it is also important that the U.S., European and Japanese
officials foreswear competition over the international roles of their currencies. (See Prof.
Kaji’s paper presented at this conference.) Some Europeans will be sorely tempted topromote the euro through diplomacy and official measures. But the right way to promote
the euro is by integrating, broadening and deepening the European financial market,
making the euro more attractive. A similar logic applies to strengthening theinternational role of the yen. This kind of competition should be welcomed byinternational partners.

Conclusion

This presentation has made several arguments, of which I wish to highlight four inconclusion. First, the monetary union has been successful and will probably come to beseen as in the interest not only of Europe but the rest of the world as well. Second, there
is nonetheless more work for Europe to do to consolidate this success and prepare themonetary union for enlargement. These tasks include introducing greater flexibility into
the economy in general, labor markets in particular, and completing the pan-European
capital market. Third, the Stability and Growth Pact should be revised to focus on
structural rather than measured deficits, to make pro-cyclical adjustments unnecessary;
but this change should be accompanied by further measures to bolster the credibility of
the revised pact. Fourth, the monetary union should strengthen its institutional capacity
to implement an active external monetary policy and coordinate action with the UnitedStates, Japan, and other countries. Such measures would help to ensure that the
infrastructure for cooperation is in place when it is needed to facilitate smooth payments
adjustment and safeguard international financial stability.

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