Europe has been moving toward a single money for almost two decades. The single money, the Euro, is scheduled to become legal tender on January 1, 1999. European policy makers have been pursuing tight monetary and fiscal policies since the start of the U.S. recovery early in 1991. The result has been economic stagnation and rising unemployment, save for the United Kingdom, Spain, and Italy, which broke away in September 1992 from the rigid exchange rate mechanism that is the predecessor of the single money. The stagnation has been particularly acute in France, but even Germany, Europe's traditional economic powerhouse, has not escaped rising unemployment and widespread departures of new plant locations by its leading corporations. Still, monetary union will probably occur on schedule.

 

Threats to Monetary Union

Confidence in a smooth path to European monetary union was shaken early in June when the Socialists in France scored a surprise election victory over the Center-Right coalition of French President Jacques Chirac. The French election result was a clear protest against the tight fiscal and monetary policies in place to ensure French compliance with the budgetary and inflation criteria for monetary union. In light of the French electorate's protest against high unemployment and persistent economic stagnation, the question now is, Will European leaders allow softer fiscal and monetary criteria in the preliminary steps toward the new European money, or will they delay, in effect terminate, the progress toward monetary union? The answer, if monetary union is a political goal as European leaders say it is, is clear: soften stringent fiscal and monetary policies and begin to combat high and rising unemployment in Europe. With Europe's large unused capacity, the initial effects on European inflation, which is already low, will hardly be noticeable.

The "easing" option to combat rising unemployment evokes concern from Germany--and especially from Germany's central bank, the Bundesbank--that such easier policies would ultimately be inflationary. The conventional wisdom fed to American observers of the European scene, largely through London, is that most Germans remain deeply attached to the views and policies of the inflation-obsessed Bundesbank. Given Germany's subpar economic performance, with unemployment at the highest level in twenty-five years, belief that Germans are highly satisfied with these stringent budgetary and monetary policies of the Bundesbank and the German government suggests that an obsessive fear of inflation has made Germans somehow indifferent to employment and economic growth.

While it is true that Germans prefer low inflation and German history has provided ample evidence of the damage of high and runaway inflation, it is not clear that all Germans applaud the stringent policies of the Bundesbank. Indeed, many Germans consider that a positive aspect of monetary union in Europe, aside from the usual benefits of a broader currency area, will be to rid Germany of what they see as the overly tight monetary policies of the Bundesbank. The breakaway from the straight jacket of the European exchange rate mechanism in September 1992 by the United Kingdom, Spain, and Italy has led to far superior economic performance in those countries, with moderating inflation. Some Germans surely must wonder if such an option is not available to them if they were only able to escape the strictures of Bundesbank monetary policy.

The move toward monetary union includes a new European Central Bank scheduled to begin operation on January 1, 1999. The new ECB as it is called would include representation from all the member countries of the European monetary union and in effect offer considerable dilution of the power of the Bundesbank.

The actual desires of Germans regarding European monetary union and the implied future course of economic policy in Germany will be able to find expression in a series of German elections during 1998 that culminate with the election contest for chancellor in October. Germany's Chancellor Kohl has clearly identified himself with achieving monetary union, although, like most politicians, he has had to reassure those concerned about inflationary threats that the new European institutions, and in particular the European Central Bank, will be as vigilant about guarding against inflation as the Bundesbank. The fact that the French electorate has clearly signaled a desire for more accommodative policies, coupled with a need to keep the German and French currencies rigidly fixed before and after currency union, complicates Kohl's task of convincing some skeptical Germans that the move toward European monetary union is anything other than a way to reduce the power of the Bundesbank. By supporting the move toward monetary union and the inevitable relaxation of monetary stringency it entails, Kohl is betting that the majority of Germans, including far more than those vainly searching for employment, desire some relief from the severe policies of the Bundesbank.

The Goal of Monetary Union

Stepping back from the immediate events surrounding the movement in Europe toward a single money, we should find it useful to observe that over twenty-five years ago European leaders conceived of monetary union as a means to political union. The usual course to a single money, however, is political union first, in a geographical area over which a single federal government enforces broadly uniform rules of commerce and manages tax and spending policies, before a common money is introduced. Europe is undertaking an unusual experiment by initiating monetary union before full political union. The stated aim is political, to use monetary union to increase political cohesion in Europe. Chancellor Kohl puts it more bluntly: "European Monetary Union is a necessary condition to increase the political cohesion in Europe in order to prevent another disastrous war in Europe." Some Germans born after World War II may fail to see the logic of Mr. Kohl's reasoning.

While the goal of European monetary union is a noble political one that probably will be achieved, awkward economic realities are causing some difficulties as we move closer to January 1, 1999. On that date, Europe's monies are scheduled to be irrevocably frozen together, and the new currency of all Europe, the Euro, is to become legal tender, while the European Central Bank takes over the management of European monetary policy.

A leftward shift in European politics has been superimposed on the late stages of the move toward monetary union. The French election, which brought Pierre Jospin to power early in June, ushering in a Socialist-Communist coalition government under Jospin that must cohabit with the Center-Right presidency of Jacques Chirac, is one example. The election of Tony Blair in the United Kingdom, whose participation in the European monetary union is as yet undecided, brings in a Labour government after eighteen years of conservative Tory leadership. It is important to note, however, that Blair and Jospin represent very different political movements. Blair's election in the U.K. represents a successful shift of a traditional left-wing party toward the center, pursuing enlightened, market-oriented economic policies. French Prime Minister Jospin represents, in contrast, old-style left-wing policies that include raising the minimum wage, shortening work hours, and attempting to use the economic system to make transfers from capital to labor. Jospin is probably an accidental prime minister, the result of gross political miscalculation by President Chirac. When Chirac decided to call an election to consolidate his position for the final move toward monetary union, he essentially announced to the French people that continuing to maintain a Center-Right majority in the Parliament would ensure two more years of the stringent monetary and fiscal policies that have caused France to suffer considerably over the past decade. To its credit, the French electorate said non.

Still, Jospin and the French Socialists have a strong commitment to monetary union, with much of the heavy lifting along the path to monetary union having been done by French President Mitterrand, himself a prominent Socialist. Further, Jospin has, since his election, reiterated the commitment to European monetary union.

In effect, France and Germany have simulated monetary union for most of the 1990s by maintaining a rigid parity between the franc and the deutsche mark, with an interruption in September 1992 when European currencies were permitted to deviate more from their central parities to accommodate the strains associated with the departure of the United Kingdom, Spain, and Italy from the exchange rate mechanism. The system of rigid parities in Europe has provided an uncomfortable preview of the shape of Europe's economies if the new European Central Bank follows policies as strict as those of the Bundesbank.

U.S. economic performance provides a useful benchmark against which to judge that of core Europe. Between 1992 and the end of 1996, French employment actually fell by 12 percent. Some have suggested that this drop is due exclusively to inflexible labor markets, which can be adjusted to provide more employment in France. The political success of French Socialists, however, who have protested specifically the movement toward more flexibility in labor markets, has diminished that likelihood. Beyond that, capital investment in France has languished, with investment flows in France late in 1996 at about 7 percent below levels in 1992.

Even Germany has not escaped the economic costs of the stringent policies pursued over the past half-decade. In late 1996, German employment was 6 percent below its 1992 level, while German investment was still 2 percent below its level in 1992.

By contrast, between 1992 and 1996, U.S. employment rose by 13 percent, while U.S. investment rose by 45 percent. For Italy, Spain, and the United Kingdom, countries that departed from the exchange rate mechanism in 1992, performance is closer to that of France and Germany, with Spain and the United Kingdom experiencing only about 2 percent increases in employment while Italian employment has actually fallen about 7 percent. In Spain and Italy, investment is still 3 to 4 percent below its 1992 level, while in the United Kingdom investment has risen by a moderate 8 percent.

Conflict over Standards

The move toward monetary union in Europe has presented its leaders with a classic struggle between means and ends. By setting monetary and fiscal standards to be met by the first group of members included in the first round of membership of the European monetary union, Europe's leaders hoped that they would be able to impose the discipline necessary to pare back budget deficits and ensure that a unified Europe is a noninflationary Europe. They are now struggling with the reality that as the date for currency union draws closer, the economic cost of having maintained stringent policies is becoming more obvious and a greater political liability, as demonstrated by the election of Socialists in France.

The contrast between the substandard performance of European economies and the extraordinary performance of the U.S. economy is also a problem for European leaders. Europe's major corporations are already abandoning operations in core Europe in favor of more cost-effective operations in either Eastern Europe, emerging Asia, or North America. This move of course is adding to the unemployment problem in Europe and also subtracting from the tax base necessary to maintain generous social benefits. The more innovative segments of Europe's business community have noticed the superior performance of American companies and banks and have responded.

Oscillations between easy and stringent economic policies have punctuated the countdown to actual achievement of European monetary union. Unfortunately for Italy, its prospective membership in the monetary union has become a symbol of whether the new European money will be "hard" or "soft." Italian budgetary policies have been historically loose, leaving Italy with a ratio of government debt to gross domestic product well over 100 percent. Italy is now struggling to change its pension and welfare programs so that they do not cause a massive increase in the government's fiscal problems. The German Bundesbank strongly opposes Italian membership in the "first round" of European monetary union, preferring to force Italy to wait until it has demonstrably addressed its fiscal problems. While the Center-Right French government shared a willingness to leave Italy out of the first round of monetary union, the newly elected Socialists have specifically advocated early membership for Italy, Spain, and Portugal. Spain and Portugal seem less troublesome to the Germans, since those countries have addressed their fiscal problems more aggressively and have achieved a remarkable economic performance without inflation that many Germans must in fact envy.

Over the past two years the struggle between fiscal orthodoxy and political imperative has produced a number of stages in the path to monetary union. In the fall of 1995, Europe's major corporations and banks, needing to begin the considerable reprogramming and infrastructure building that would accompany a common European currency, asked their governments if the commitment to starting the monetary union on January 1, 1999, was firm. They were given a strong yes and told to go ahead with preparations.

A year later, in the fall of 1996, fiscal stringency began to slip out of fashion as European economies slowed. It was pointed out that the Treaty of Maastricht, the document governing the conditions for satisfying monetary union, did not specify in the treaty itself fiscal goals in terms of ratios of deficits and debt to GDP but rather only satisfactory progress toward achieving fiscal discipline. This wording was taken to mean that the goal of deficits at 3.0 percent of GDP and government debt at 60 percent of GDP suggested as guidelines in the treaty were not rigid targets. The notion began to emerge that Italy could be included in the first round.

The German reaction to more relaxed attitudes toward the treaty's fiscal criteria resulted in the postulation of the Stability Pact by German Finance Minister Theo Waigel. The Stability Pact was designed to reinforce the commitment of European governments to fiscal discipline before and after the inception of monetary union.

The German Stability Pact was the focus of discussions among European leaders at the Dublin meeting of European ministers in December 1996. The result of the Dublin meeting, with the French playing a key role, was to render the Stability Pact harmless as a means to impose fiscal discipline.

The Germans reacted to the watered down Stability Pact during the spring of 1997 by insisting that the Italians could not be included in the first round of monetary union. Having been rebuffed on the Stability Pact, the Bundesbank especially was insistent that the Italians had not achieved sufficient fiscal discipline to satisfy the spirit of the terms of the Treaty of Maastricht. The Bundesbank maintained this orthodoxy against an increasingly uncomfortable recognition that even the Germans would probably not meet the strict criteria of the Maastricht Treaty, and now, given the mandate of the new Socialist government in France, France too will fall short of the strict interpretation of the fiscal criteria. Under these conditions and with the advocacy of Italian membership by the French, it will be difficult to exclude Italy from the first round.

The real question facing Europe in the final eighteen months before the designation of the new Euro as the legal tender of much of Europe is whether the strict interpretation of the Maastricht Treaty criteria will be relaxed to whatever degree is necessary to include most of Europe among the initial members of the union.

The fiscal criteria of the treaty will be relaxed simply because none of Europe's major countries, nor most of its minor countries for that matter, can meet the literal terms of the treaty. The only risk to achieving monetary union on time would be a protest either from the Bundesbank or from the German public, uncomfortable with the lack of fiscal discipline and an attendant lack of monetary discipline under the new unified currency of Europe. Potential monetary union protesters in Germany, however, will have no specific target to shoot at until March 1998, when the European Monetary Institute, the predecessor to the European Central Bank, renders its judgment on the countries that have made satisfactory progress toward the criteria of the Maastricht Treaty. Between now and then, there will be plenty of arguing, especially between the French and the Germans, about the degree of fiscal stringency required to satisfy the treaty and symbolically about whether Italy should be included in the first round of membership. This period of wrangling will probably produce two results. First, most European currencies, including the deutsche mark, which will probably not exist in eighteen months, will weaken against the U.S. dollar. This will have the useful side effect of giving some boost to Europe through extra export sales, although the ability of relatively high cost European firms to compete with American firms may limit that effect.

A second result of the pre-union wrangling will be some relaxation of the fiscal controls in Europe. The Europeans will thus have somewhat larger budget deficits as they enter monetary union in 1999. The Bundesbank will be unlikely to counter such moves with higher interest rates, although it may resist any further reduction in interest rates, even if weaker economic conditions should argue otherwise.

Conditions for Successful Union

Should the relaxation of fiscal stringency and a Bundesbank on hold encourage an economic recovery in Europe, a condition that would greatly enhance the chances for successful monetary union, there could be some effect on the economic fortunes of the United States. Of course, U.S. exports to Europe would be increased by an economic recovery. A truly powerful European economic recovery, which I emphasize is not very likely, would increase global demands on commodity markets and probably eliminate some of the unusually favorable conditions that are now allowing the U.S. expansion to continue along a noninflationary course. A strong economic recovery in Europe would also mitigate and perhaps reverse the dollar's strength, a result that seems unlikely if European economic performance remains tepid during the journey toward monetary union along likely lines of stringent fiscal and monetary policies.

Whatever the ultimate outcome of the push for increased political union by way of monetary union, events in Europe bear careful watching. Successful achievement of monetary and political union would represent an additional post-cold war bonus: the union could bring about an extended period of peace in which European nationalism could subside and economic growth could prevail.

The major risk is that Europeans will achieve monetary union without rationalizing the generous program of social benefits or establishing fiscal discipline. If Europe simply declares victory by freezing its exchange rates together, without making the needed structural changes in the economy, European monetary union will not survive for very long without resorting to a highly counterproductive increase in trade protection. That outcome would constitute a tragic confusion of means and ends, with Europe bearing the major portion of the costs.

John H. Makin is a resident scholar at the American Enterprise Institute.