Global order and the future of the euro.

• Author: Schwartz, Anna J.

The performance of the euro can be assessed in relation to recent developments in the global economy as well as in relation to the vision of the architects of the European Monetary Union. I shall consider both perspectives and ask whether the EMU has lived up to the vision of its architects to create a new currency to serve as a bulwark for maintaining price stability over the medium term.

The Euro in the Global Economy

In a study for the National Bureau of Economic Research, Michael Dooley, David Folkerts-Landau, and Peter Garber (2003) describe recent developments in the global economy as attributable to the behavior patterns of countries in three geographical areas. The United States is one of the geographical areas. It is the center country of the global economy, and the system's financial intermediary. It does not manage its exchange rate and does not accumulate foreign reserves. It is both a trade account country and a capital account country. It seeks growth through its trade account and finance for its growth. It seeks investment through its capital account and foreign savings to finance domestic capital formation. The United States does not worry about its deteriorating international investment position.

A second geographical area is Asia, comprising China, Taiwan, Japan, Hong Kong, Singapore, Korea, and Malaysia. Asia is a trade account region. Exporting to America is Asia's main concern. Exports mean growth. Their growth-oriented trade surpluses are a source of finance for the United States, channeled through their central banks as official providers of capital to the United States. The Asian countries manage their dollar exchange rates, and their central banks consistently intervene to limit appreciation of their currencies. Exchange controls and administrative pricing are often resorted to. Some currencies are explicitly fixed, like the Chinese yuan, the Hong Kong dollar, and the Malaysian ringit. The Japanese yen and Korean won float but Japan and Korea accumulate vast official reserves in U.S. dollars. The Asian country currencies float against the currencies of the third geographical area.

The third geographical area comprises Europe, Canada, Australia, and Latin America. This is a capital account region. Private investors in the capital account region care about the risk/return of their international investment position, and have recently become worried about their U.S. exposure. Countries in the capital account region have floating exchange rates. Their governments do not intervene, and their official reserves have not increased.

The trade-weighted exchange rate of the German mark and then the euro and other currencies of the capital account region depreciated substantially relative to the dollar from 1992 through 2002. The real exchange rate depreciation was consistent with private investors of the region helping to finance the U.S. current account deficit.

Over the last five years, however, the U.S. current account deficit has been financed by official inflows from the trade account region as well as private inflows from the capital account region. The surge in the U.S. current account deficit has been the engine for growth in the rest of the world.

Until early 2003, the tripartite global economy was stable and sustainable in view of the trade account region's preference for official investments in the United States and the capital account region's preference for private financial investments in the United States. Lately, however, the countries in the capital account region have become concerned about the rise in U.S. international debts. The depreciation of the euro and other capital account region currencies was reversed in 2003. Normally, the solution would be for U.S. yields to rise and the dollar to depreciate sharply. The dollar has depreciated, but may not persist, and U.S. yields may not rise.

Instead, Asia may displace Europe in sending exports to the United States and may be ready to accept even larger...