Number 165, July 1999
**U.S.-European Union Relations: *Economic Change and Political Transition*
by Steven Philip Kramer and IreneKyriakopoulos**Conclusions- The European Monetary Union (EMU) will affect the    economic balance of forces between the European Union and the United States. 
- The introduction of the euro as the currency of    the EMU will aid participating European Union (EU) member states by eliminating    transaction costs, exchange rate risks, and interest rate spreads across the 11 European    currencies early in the coming century. 
- The proportion of international transactions and    assets held, in euros, could approximate that held in dollars within 10 years. 
- The U.S.-European political relationship is    increasingly disconnected due to the lack of a common external threat, with the United    States being concerned about threats to global security and European states focusing on    the EMU and unemployment problems. 

U.S.-European relations are going through a periodof fundamental readjustment. In the economic and financial arena, the introduction of theEuropean Monetary Union (EMU) creates the conditions for a truly supranational Europeanidentity and, ultimately, a change in the economic balance of forces between the EuropeanUnion (EU) and the United States. In the political arena, the U.S.-European politicalrelationship is becoming increasingly disconnected. 

The introduction of the euro, as the currency of theEU, is an event of historic importance for European economic integration and for theworldwide financial system. With the implementation of the first stage of this economicunion last January, the EMU is transforming the world of business, commerce, and finance.Conversion rates of the 11-country national currencies have been irrevocably fixed, andthe euro is trading in foreign exchange and money markets; the European Central Bank hasstarted to operate; new financial instruments, including bank accounts, are issued ineuros; and accounting, retail pricing, and business invoices in euros are used in parallelwith national currencies. Euro notes and coins are being produced for circulation in 2002,when they will replace national currencies. By July 1, 2002, the euro will be the onlyform of legal tender in participating member states. With economic integration thusexpanded, Europe's experiment with a supranational union is moving into a new phase. Therelationship of the EU with the United States is likely to change, as Europe's growingfinancial, commercial, and economic clout affects the distribution of resources on aglobal scale.
**The Effect of the EMU on the European Identity

The significance of the EMU in forging a moredynamic European identity should be evaluated in terms of its impact on the internationaleconomic system. The economic space of the EU involves 300 million inhabitants andcommands a gross domestic product (GDP) larger than the United States’ even though ithas yet to match America in terms of per capita income. Internationally, the EU is theworld's largest trading partner, but nearly two-thirds of international transactionsinvolve the U.S. dollar. The EMU will alter these relationships.

For a number of reasons, the advent of the EMUimplies an erosion of the dominance of the U.S. dollar in international trade and finance;the euro's importance will eventually match that of the dollar. By replacing 11 Europeancurrencies, the euro will become a key international reserve currency. More significantly,the absence of transaction costs, exchange rate risks, and interest rate spreads acrossthe EU can stimulate the development of a truly integrated financial market in the wholerange of financial instruments and activities, including securities trading, pensionfunds, retail banking, and insurance. According to estimates prepared for the EuropeanCommission, within 10 years the proportion of international transactions carried out ineuros and assets held in euros will approximate the amount currently held in dollars.Portfolio shifts will also take place as the supply of financial assets in euros continuesto grow. Non-EU countries will be affected by the euro, most directly via internationaltrade relations. Trade is expected to increase gradually but steadily as a result ofeconomic growth following completion of the EMU. Indirect effects may be even moreprofound and global because the euro will serve as a vehicle currency (one thatfacilitates financial transactions) in foreign exchange markets, and as an invoicingcurrency (one that facilitates billing) in international trade, with a growing role incapital markets.
**The Trade and Investment Relationship

The importance of the trade and investmentrelationship between the United States and the EU is likely to grow in the new tripolarinternational financial environment dominated by the U.S. dollar, the European euro, and,to a lesser extent, the Japanese yen. The ascent of the euro as a key currency in theconduct of international transactions will make it more difficult for the United States torun large external deficits financed by the issue of dollars, since there would be lessdemand for them. Correspondingly, the EMU would find it easier to run external deficitswithout a depreciating currency. In practice, the EU would likely run smaller tradesurpluses as the United States reduced its trade deficit. As a consequence, there will beincreased pressure for fiscal policy coordination among European countries. By the sametoken, the United States and the EU will need to develop cooperation between the FederalReserve and the European Central Bank in monetary policy.

These developments are likely to lead to realignmentof economic priorities and may necessitate change in policy choices. A successfultransition to a single currency will reward the efforts of EU member states towardeconomic convergence but it does not address the critical problem of unemployment inEurope which has remained unacceptably high throughout the l990s. The choice of pursuing alooser monetary policy and a weaker euro cannot be ruled out now that center-leftgovernments are the norm in the EU; in fact, this may become the policy of choice. Underappropriate conditions, a weak euro would promote higher growth and lower unemployment; inthis case, a weak euro would pose an even stronger challenge to the dollar to the extentthat it would enhance the utilization of resources in Europe's economy.
**Strong versus Weak Euros

There are some indications that the EU isconsidering a more lenient interpretation of the inflation criterion in assessing futureEMU membership. Such a move may be necessary, because the challenge facing all EU memberstates is not one of price stability; it is the poor record of most EU economies increating jobs and reducing unemployment. If these concerns are shared by the EuropeanCentral Bank and incorporated in its euro-dollar exchange rate policy, they could helppromote a weaker euro and ultimately reduce unemployment rates. However, a weaker euro,that would further improve Europe's trade position, would give rise to stronger calls forprotectionism in the United States. Such developments might represent something greaterthan simple inconvenience and could force a change in America's domestic economic policypriorities; measures to reduce the trade deficit would require continuing fiscaldiscipline and budgetary restraint.

For the United States, success of the euro isimportant because it will help modernize and strengthen the economy of Europe whichremains America's most important trading partner. At the same time, the euro's successwill require long-term adjustments. The ability of the United States to sustain its largetrade deficit position will be constrained by reduced financial inflows, and measures tooffset inflationary pressures might ultimately become necessary. The greater the successof the euro, the more certain it is that U.S. financial supremacy will be challenged andits economic policy reoriented accordingly.

Thus, Europe's transformation into a truly unifiedeconomic space will inevitably lead to a change in the EU-U.S. relationship in the 21stcentury. Economic transformation has security dimensions. If EMU is a prelude to Europeanpolitical unification and paves the way for the creation of a truly supranational Europeanidentity, it can lead to realignment in the distribution of power in the internationalsystem as a whole. The resulting changes, which will be gradual and incremental but alsoinevitable, can influence international security relationships.
**A Divergent Political Relationship

The development of the EU as a truly unifiedeconomic space is occurring even as the U.S.-European political relationship is becomingincreasingly disconnected. The dissolution of the USSR ended a period in which a massiveand immediate threat to the common interests of the United States and Western Europeforged an enduring bond. Although tensions between the United States and Europe existed,the necessity of their security relationship could not be challenged. NATO was theinstrument of the U.S. role in Europe and the only real instrument of European security.The European Community was an economic organization with a political but not a securitydimension.

The situation is dramatically different today, forseveral reasons. First, NATO is now an optional alliance. It provides insurance against aresurgence of the Russian threat and against new but ill-defined future threats of alesser scale. For this reason, America has supported NATO enlargement and a new strategicconcept emphasizing common Western interests, rather than territorial defense, as aprimary NATO function. This has been based as much on an American desire to remain aEuropean power as a response to genuine outside threats. It has been aimed at a domesticaudience as well, for internationalists fear isolationist feelings lurking in the Americanpeople. Second, the discipline of bipolarity imposed by Cold War has eroded. As the ColdWar recedes, historical fault lines reappear along with rancorous partisan politics insome nations. The presidential impeachment process exemplified this trend in the UnitedStates and in Russia. Third, the EU assumed a security and defense identity at Maastrichtin 1991 and European cooperation on foreign, security, and defense cooperation is greaterthan before.

**Intra-European Focus.** There are currently twogreat disconnects in U.S.-European relations—Europe's preoccupation withintra-European affairs and its concurrent desire to control its own destiny. The firstdisconnect is that the United States wants Europe to do more on global security but Europeis generally reluctant. There has been a civilianization of much of European society, anallergy to the use of force as an instrument of foreign policy, especially notable inGermany and in the North. Europe is inward-looking, its plate full of grave and weightyconcerns. The EMU, the greatest European initiative in decades, has required years ofdiscipline, commitment, and sacrifice and cannot be allowed to go awry. Unemployment hasbecome the big problem of Europe. Failure to resolve it has led to the defeat of rulingparties and their leaders. But the victors know that the clock is ticking and that it isnot far from the capitol to the Tarpeian rock. 

There is an increasing willingness to attempt todeal with the politics of unemployment and economic growth on a European level. Indeed, itis likely that the European solution will involve a more centrally inspired EUintervention rather than an American-style free market approach. The rise of extremist andfascist parties, like the French National Front, has resulted mostly from the failure ofgovernments to deal with the politics as well as the economics of unemployment. Then thereis the crisis of the welfare state, which no one wants to tackle head on.

Still, something far more profound is alsooccurring. For hundreds of years, the essence of West European history has been the riseof nation states and their eventual democratization. But history is on the move again.Economic integration is evolving in a climate of political devolution. The nation state iscaught between loss of power from above—first to NATO and then to the EU—and nowfrom below—to assertive regional and subnational loyalties. 

We cannot assume that even states in Europe andelsewhere which have seemed firm and eternal will continue to exist as we have known them.Canada, as the Quebec elections indicate, could dissolve. In Italy, federalist and evenseparatist feelings are palpable in the North, and a new constitution still needs to bewritten. In Spain, the political system may need to be revised to increase the alreadyconsiderable powers of the Basque and Catalan governments. In Belgium, the power of theregions is already great, and the central government is more and more shadowy. Finally, inthe UK, Prime Minister Tony Blair has undertaken risky and fundamental changes of theunwritten constitution and has begun the process of devolution in Scotland and Wales. Thishas already led to a separate regional parliament for each, and there is a real potentialfor Scottish independence. 

At the same time, even though EU enlargement isunavoidable (and the EU is officially committed to it), the EU is displaying greatreluctance and hesitation; therefore, the process is delayed. Enlargement requiresrenegotiation of the basic institutional structure of the EU and its finances, whichstrains the political will of member states. If we admit that all politics is localpolitics, we can understand why Europe is preoccupied with these issues and, therefore,reluctant to shoulder more responsibilities elsewhere, as the United States would like.

**Security Responsibility versus Security Burden.**The second disconnect, which is often perceived to be in contradiction with the first, isthat Europe wants greater control over its own destiny. It is tired of being an economicgiant but a political dwarf. To the American thesis that European security is best treatedin the Atlantic framework, with NATO as the main instrument and the United States as theleader, there exists a rival thesis of a European Europe—that the EU should take moreresponsibility through its own security and defense identity. The proponent of thatthesis, not surprisingly, is France. Alone of the old nation states of Europe, France didnot accept its demise as a global player. Recognizing the limited capacities of amid-sized state, it transposed its ambitions to the EU. The EU was seen as a France writlarge.

The French ambition is plausible but suffers fromtwo defects. First, in general, Europeans still want the United States around. Second,Europe is not anxious to assume the greater burden and responsibility this thesis implies.The result will be continuing European ambivalence between the American and French pointsof view, usually manifesting itself over specific crises, such as policy toward Iraq andthe use of unilateral sanctions. Therefore, tensions between the United States and Europe,and more particularly between the United States and France, will continue.

In conclusion, we can anticipate a difficult periodof transition marked by serious tensions in U.S.-European relations. It may be tempting tointerpret the successful termination of the NATO air campaign against Yugoslavia as a signthat strong common interests prevail; that the transatlantic relationship between theUnited States and Europe reflects solidarity, consensus, and a single world view; and thatthe future of U.S.-European relations rests firmly on the shared heritage of global marketeconomics and liberal democratic politics. Yet achievement of NATO’s stated aims willstill mean that the United States and Europe will have to face and solve the complex andcostly problems of a regional settlement, to include rebuilding of Yugoslavia. Europeansmay decide to develop the capacity to defend their security interests, but it is uncertainthat the hard budgetary decisions will be made to support such a decision. Also, financialvolatilty and economic turmoil generated by the war in the Balkans could endanger theeuro. American hesitation toward future financial initiatives and contributions aimed atregional reconstruction in the Balkans could further complicate relations. Failure toachieve short-term political objectives and long-term economic development goals could bea source of open discord in both NATO and the EU.
**Recommendations- If the United States values the transatlantic    economic, political, and security relationships it developed during the Cold War, it    should become more cognizant of the changes the European Monetary Union will bring to    world financial and trade markets and take the steps needed to accommodate the competition    this will engender. 
- Discrepancies between the global view of security    threats held by the United States and the intra-national economic and unemployment view of    the EU states should be accepted as practicable differences in sovereign viewpoints. The    United States should continue to urge the EU states to pay attention to rising global or    regional threats that may affect EU interests as significantly as unemployment or    financial union. 
- Policymakers should bear in mind that the    political nature of, and the political boundaries of, even its closest transatlantic    allies are subject to change. 

Steven Philip Kramer is Professor of Grand Strategy and IreneKyriakopoulos is Professor of Economics at the Industrial College of the Armed Forces,National Defense University. For more information call Dr. Kramer at 202-685-4213 or Dr.Kyriakopoulos at 202-685-4384. Opinions and conclusions expressed or implied in this paperare solely those of the authors and do not necessarily represent the views of the NationalDefense University, Department of Defense, or any other government agency.

The Strategic Forum provides summaries of work by membersand guests of the Institute for National Strategic Studies and the National DefenseUniversity faculty. These include reports of original research, synopses of seminars andconferences,the results of unclassified war games, and digests of remarks by distinguishedspeakers.

Editor in Chief - Hans Binnendijk

Editor - Jonathan W. PierceNOTE

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