U.S. imbalances and the euro's outlook.

• Author: Rogoff, Kenneth

It is difficult to discuss the euro in purely economic terms because the euro is fundamentally a political issue. Many things go on in the name of the euro. If you ask Europeans about the euro, they will raise issues ranging from European integration to democracy to education to the weather in Provence. Many positive steps have been taken in the name of euro. For example, the Stability and Growth Pact, for all its flaws, has been wonderful for the smaller countries. But at the same time, the SGP has little connection with being in a currency union. The direct economic effects of currency union are often overstated. Indeed, there is much debate and it is not at all obvious that currency union is a net positive in narrow economic terms.

Perhaps the single most important direct economic effect of the euro has been to create deeper financial markets in Europe. Unfortunately, the benefits from those markets may be a long time coming if takeovers and mergers remain difficult, and labor markets continue to be rigid. In the United States, financial deepening has allowed money to suddenly shift from one part of the economy to another, often to the dismay of managers who are seeing their companies being taken over. And the system works also because labor markets are reasonably flexible. Without the ability to displace workers, industry consolidation would be difficult, and the benefits of financial integration would be much less. Deepening European financial markets is important, but it is only a first step.

The Short-Term Challenge

The biggest short-term test for the euro will be what happens to the global monetary order when the U.S. current account is brought into balance. I agree with Fed Chairman Alan Greenspan (2004) that as the global economy becomes more flexible, the adjustment process becomes less burdensome. But how flexible is the global economy? Europe certainly isn't. Japan isn't. Latin America isn't. Also, it is quite wrong to think that just because capital markets are deep, commodity markets can seamlessly adjust to a giant shift in global demand toward the United States and away from the rest of the world--which is exactly what a closing-up of the U.S. current account deficit must imply. Hence, I believe that it is very likely that when the U.S. current account reverses, there will be a sharp drop in the dollar and an adverse effect on global output. Maurice Obstfeld and I presented a model of this phenomenon three years ago at the...