The Euro Risk

The American public and officials in Washington are underestimating the risks to the U.S. of the new European Economic and Monetary Union, and its new currency, the euro. The reason for concern is not that the EMU will mean a stronger Europe that can challenge the U.S. economy. Quite the contrary, the EMU is likely to weaken European economies, leading to more trade friction and economic isolation. But the most important problems the EMU can cause are political, bringing increased conflict within Europe and with the U.S.

The EMU is ostensibly about substituting the euro for 11 national currencies and transferring responsibility for monetary policy from individual national central banks to a new European Central Bank, but the EMU's real importance is political. The advocates of the EMU see it as an important step toward creating a strong political union. The idea of a United States of Europe was conceived at the end of World War II by politicians who believed that abolishing national governments would prevent a repetition of the major wars that had engulfed Europe during the previous 75 years.

Although this argument seems far less persuasive after 50 years of European peace, the single currency is applauded by European federalists as an important step toward a federal government. Since there is no major country in the world that does not have its own currency, abolishing national currencies is a major move toward abolishing European national states. When Spaniards and Italians have euros in their pockets instead of pesetas or lire, they are bound to feel more like "Europeans."

Transferring monetary policy to the new European Central Bank is a major step in shifting power away from national governments. Although the motivation for the move to a single currency is political, it will have important economic effects. European countries will have higher unemployment because a single currency and a one-size-fits-all monetary policy will not be able to accommodate national differences in cyclical conditions. Outside the EMU, when growth slows and unemployment rises, a fall in a country's interest rates can provide an offsetting stimulus to demand. But with a single currency for all Europe, there can be only one set of interest rates. The European Central Bank will make decisions based on the overall economic conditions in Europe, essentially in France and Germany. A smaller country with weak demand will just have to accept rising unemployment unless there is also weak demand in the larger countries, as there happens to be now.

Europeans who point to the employment success of the U.S. as evidence that a single currency will not raise European unemployment do not recognize the important labor-market differences between Europe and the U.S. When local employment declines, Americans move to areas where jobs are more plentiful; that is unthinkable in a Europe divided by linguistic and cultural barriers. And American wage flexibility allows employment to remain much more stable when the availability of local jobs declines.

The EMU is also likely to put Europe on a path of rising inflation. The decline in European inflation over the past 20 years has been the result of the dominant leadership of Germany's fiercely anti-inflationary central bank. Other European countries had to follow Germany's low-inflation policy or accept the destabilizing consequences and political embarrassment of currency devaluations in relation to the deutsche mark. With a single European Central Bank, Germany can no longer be the standard setter for Europe. The end of that leadership in monetary policy, and the associated rise of political influence over monetary affairs, is a clear recipe for higher inflation.

The EMU means "economic" as well as "monetary" union. There is official talk about harmonizing taxes, employment rules and other policies that are currently made by national governments in order to reduce the competitive advantage enjoyed by European countries with lower tax rates and more flexible labor markets.

That coordination will be a serious mistake. Europe today has an average unemployment rate of more than 10% and is simply not creating private-sector jobs. This chronic problem reflects high payroll taxes, inefficient work rules and a tax and regulatory system that discourages entrepreneurial activity. Standardizing tax and industrial policies will exacerbate these conditions by eliminating the competitive pressure that would come from national experiments with alternative policies.

Reducing policy competition among the nations of Europe will therefore reduce the ability of European companies to compete in world markets. The result will be increased trade friction with the U.S. and other countries as Europe attempts to block American and other non-European products on the ground that they are made under "unfair conditions," i.e, in countries with lower tax rates and more flexible labor markets.

All this in turn will be a cause of European conflict rather than the increased harmony that the original proponents of a federal Europe wanted. Governments are already protesting the attempt to harmonize taxes. Future experience with cyclical unemployment and rising inflation will justifiably provoke angry politicians to blame domestic ills on the decisions made by the representatives of other European countries. The frustration over the inability to influence one's own national economic affairs is likely to become an increasingly difficult problem within Europe.