The euro facing other moneys.

• Author: Yeager, Leland B.

My attitude toward the euro could make me fair game for President Truman's complaint about not finding a one-armed economist. On the one hand and on the other, I'll hasten over the familiar pros and cons. I'll spend more time on the political centralization that the euro seems to imply. I'll conclude by pointing out defects that the euro shares with all modern currencies.

Standard Pros and Cons

A common currency can be more durable than supposedly fixed exchange rates among distinct currencies. It offers convenience and economies for trade, investment, and tourism. (So far, though, the euro system has made only a small start at bringing down the astonishingly high bank charges on transferring funds even between euro countries; The Economist 2003b: 59-60.) Price discrepancies become more transparent, presumably enhancing competition in goods, services, and securities. Under the Maastricht Treaty, the euro system supposedly imposes financial discipline on member governments, and the European Central Bank is responsible above all for achieving price-level stability or only moderate inflation.

The euro's contribution to global monetary stability depends on its performance at home. While the euro ends potential competition among the currencies that it replaces, it enhances competition on the world stage by being the domestic currency of an economically and financially large area rivaling that of the United States. F. A. Hayek (1977) would have admired this aspect for the discipline it might pose against the monetary and fiscal recklessness of governments, including the U.S. government. These advantages or potential advantages, taken together, are substantial. The shortness of the list does not deny their importance.

On the other hand, the euro eliminates not only the opportunity for (quasi) independent national monetary policies but also the quasi-flexibility of prices as translated at flexible exchange rates. Suppose, for example, that a fall in foreign demand for a country's leading exports requires a change in its external terms of trade. Relative prices can adjust either through a fall in domestic-currency prices and wages or, less painfully, in part through exchange-rate depreciation. Under monetary unification or a fixed-rate system operated according to its inherent logic, the first process would operate and would be reinforced by a drain on the country's money through a temporary balance-of-payments deficit. This deflationary adjustment would depress real economic activity during the transition.

The point about relative-price flexibility arises in the literature on optimum currency areas, and its force depends on a country's production of traded goods being such that exchange-rate flexibility can indeed be a meaningful substitute for or supplement to domestic price flexibility. Related points concern labor-market rigidities and other conditions tending to recommend an independent national monetary policy. I used to give such considerations more weight than I do now (having been influenced by the literature on rational expectations); but even now I do not dismiss them outright.

Reviewing five much-discussed tests pertaining to criteria of an optimum currency area, and specifically how the Chancellor of the Exchequer found them applying to Great Britain, The Economist (2003a: 51-52) concluded that the case for Germany's quitting the euro looks stronger than the case for Britain's joining soon (a special section in the same issue, pp. 4-7, mentions Germany's "Eurosclerosis").

Currency Substitution

Already I have noted greater currency competition as a possible benefit of the euro. This is not unequivocally a good thing, however; and under the name "currency substitution" it has long aroused worry (Miles 1978a, 1978b; Lebre de Freitas 2003; Friedman 1999, 2000a, 2000b, 2002). Miguel Lebre de Freitas describes the problem: Increasing international portfolio diversification and absence of capital controls enhance investors' ability to switch where and in what currencies they hold their assets. This switching may destabilize demands for money. If the demand for money in Europe responds to monetary conditions in the United States, money growth in the euro area may become a poor indicator of risks to price stability. "Technology and globalisation are blurring the distinction between national and international uses of money, opening a channel through which domestic money markets are exposed to shocks occurring abroad. This phenomenon is a matter of concern for policymakers, as it rises the unpredictability of the money demand and reduces the effectiveness of monetary policy" (Lebre de Freitas 2003; econometric experiments suggest to him that the problem could indeed become serious).

How might substitution occur? An increase in one country's money supply, for example, might reduce interest rates or intensify inflationary expectations there, motivating capital outflows. Inflows into countries linked to the first at fixed exchange rates would expand money supplies unless sterilization were somehow successful. Even completely flexible exchange rates would not guarantee monetary independence in the countries of destination, especially if some of each country's money was held in all of the countries involved.

You might discount the dangers of currency substitution because of the inertia--the "who goes first?" aspect--that keeps people using their home currency. Yes, but shifting is not confined to currency and demand deposits. In many countries, furthermore, the dollar does circulate in parallel with the local currency. (Recent shipments of U.S. currency have continued to go mostly to Argentina and Russia, but shipments to the euro area have decelerated; Nguyen 2003: 18.) The official reserves of central banks provide much scope for shifting out of dollars into euros.

A session of the American Economic Association in Atlanta in January 2002 turned out to be mostly cheerleading for the euro, with little analysis. During the question period, however, a member of the audience asked whether the larger top denomination of euro than of dollar banknotes, 500 € versus $100, wouldn't make the euro more attractive for drug trafficking and other underground activities. The moderator of the session just brushed the question aside, apparently not understanding it; but it was a good question. The bulk of U.S. paper money in circulation, and especially of $100 bills, is held abroad, providing great scope for currency substitution. (1)

Politics and Centralization

Related to currency substitution is a worry that I want to save for later, a worry about all government currencies nowadays. Meanwhile, let's notice the euro's political role. The euro seems to have been politically motivated from the start, politicians more than economists pushed for it, and it serves above all as a symbol of European unity and statehood (Backhaus 2000, Senn 2000, Sigfrid 2003, Watrin 2002: 321-22). German Chancellor Gerhard Schroder said in a speech in the Netherlands in 1999, "The introduction of the euro is probably the most important integrating step since the beginning of the unification process. This will require us to bury some erroneous ideas of national sovereignty" (quoted in The Economist 2003c: 52; The Economist [2003a: 4-7 of the special section] mentions political elements in arguments about whether countries not yet in the euro area should now join.)

According to Benjamin Friedman, the chief purpose of monetary unification in Western Europe and some other regions is not to rearrange economies into optimal currency areas in the economists' usual sense but rather to...