EUROPE REVISITED:
CONSEQUENCES OF INCREASED EUROPEAN INTEGRATION FOR CANADA
KEY ISSUES AND CONCERNS SURROUNDING THE EMU
The EMU, along with its new currency, the euro, was launched with much fanfare on 1 January 1999. During the January 1999 to December 2001 transition period, both the euro and individual currencies are coexisting, with the euro already in use in non-cash business transactions (i.e., wholesale and electronic payments) and in financial markets. At the retail level, no change will be apparent until 1 January 2002; thereafter each country’s individual paper currency and coins are to be phased out by no later than the end of June 2002.
At present, a total of 11 countries (Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal, and Spain) have agreed to adopt the new common currency. All told, the euro-11 zone comprises approximately 300 million inhabitants and roughly matches the share of global economic output ? about 20% ? held by the United States. With economic convergence being the principal guarantee of long-term stability of exchange rates, all these countries were successful in meeting certain convergence criteria. These included adequate price stability, acceptable deficit-to-GDP and debt-to-GDP ratios, both a lowering and a converging of long-term interest rates, and membership in the European Monetary System.
So far the United Kingdom, Sweden, and Denmark have not accepted the EMU plan, fearing a loss of national control over monetary policy, while Greece did not satisfy the economic entry requirements. To co-exist with EMU members, these four countries would have to join a revamped version of the exchange-rate mechanism of the European Monetary System (the ERM2) and attempt to coordinate economic policy with that of the EU. Michael Saunders (Head of European Economic Research at Salomon, Smith Barney, London) informed the Committee that, unlike Denmark and Greece, which may enter the EMU in the next few years, the U.K. and Sweden are less likely to opt in (even though U.K. exports are being harmed by the appreciation of the pound relative to the euro).
The European Central Bank (ECB) has been created to manage monetary policy within the EMU area, and price stability has been designated as the principal criterion to be used by the Bank in administering monetary policy. Political guidance for the euro-11 members will be given by a new body, the Euro Council, composed of finance ministers from the participating countries. However, the principal decision-making body in economic policy will continue to be the regular EU finance ministers’ meetings (ECOFIN), even though the ministers of the four non-participating countries attend those meetings.
Whereas monetary policy is to be centrally coordinated, no common fiscal authority has been established for the EMU. However, the launch of the euro was preceded by a process of convergence in the monetary and fiscal policies of aspirant EMU entrants. The goal of achieving broad fiscal policy convergence remains a priority, with the Stability and Growth Pact continuing to tie EMU countries to ongoing fiscal policy discipline. The threat of sanctions against any EMU country that breaks the rules on fiscal discipline remains in place.
The key point to stress relative to the decision to create an EMU is that it was largely political. As John Murray (Chief, International Department, Bank of Canada) told us, "Europe has consciously put the cart before the horse." As already mentioned, the Committee believes that political integration was the primary motivation behind the shift to the common currency, with the economic rationale playing a secondary role. It remains to be seen whether the monetary union will lead to closer European economic integration and serve as a catalyst for economic reforms.
According to Danièle Smadja (EU Ambassador to Canada), the launch of the euro has been successful from a strictly technical and legal viewpoint. It is her view that the new currency’s credibility has been established, largely as a result of the careful preparation that preceded the launch. Indeed, the euro enjoyed a remarkably orderly entry into the global trading system. However, the reality is that the euro recorded a sharp slide against the U.S. dollar since its introduction in January of this year, having slipped from approximately $1.18 at the time of the launch to $1.04 at the beginning of November. In other words, the euro fell by a full 12% (against the U.S. dollar) in the ten months after its launch.
A number of individuals told the Committee that the euro is behaving entirely as it should and that its early performance should not be a cause for major concern. As Mr. Saunders pointed out, while there certainly was a strong political element to the euro’s weakness, its lack of strength is largely a symptom of the underlying poor economic situation in Europe compared with the robust performance of the American economy. What is more crucial, argued Christian de Boissieu (Scientific Director, Economic Observation Centre, Paris Chamber of Commerce), is the medium- and long-term credibility of the currency. For example, it is not known whether or not the establishment of the EMU will lead to the structural adjustments that are required in Europe; if such reforms do not materialize, Europe could experience economic difficulties. A continued decline in the value of the currency, reflecting continuing economic weakness, would be a worrisome development.
The main cause by far of the euro’s weakness has been the poor performance of the German economy. With Germany ranking as the third largest world economy and responsible for a full one-third of the euro countries’ output, it is no surprise that when the German economic motor stalls, the value of the European currency is adversely affected. Much of Germany’s economic weakness has been attributed to such structural factors as the high cost of an elaborate social security system, the existence of high labour costs, and a complicated and inefficient tax system. Once these deficiencies have been rectified, a resumption of higher growth and employment can occur ? so goes the argument. Other factors such as the impact of the Asian and Russian financial crises on German exports and the reduced confidence of business in the German government since the 1998 election also need to be mentioned.
The near-unanimous view of those individuals consulted by the Committee was that the fall in the value of the euro is entirely appropriate, given that Europe’s economy is weak. According to this view, Germany and other countries in Europe require a softer currency in the short term to help stimulate exports and to support growth.
The value of the euro should rise when the relative economic situation between Europe and America reverses itself, and when public and private investors begin to make use of the new currency. The point was made by Jean-Claude Trichet (Governor, Bank of France, Paris) that while the U.S. now enjoys a high rate of economic growth, there are doubts about the sustainability of this externally-financed boom. Dr. Heinz-Jurgen Scheid (External Relations Division, European Central Bank) saw scope for appreciation of the euro in the long-term, beginning with a sizeable increase in the year 2000.
In a nutshell, the EMU is expected to benefit the European economy by removing barriers to inter-EU trade and capital flows and by providing greater price stability and lower risk premiums on the cost of funds. The chief cost borne by each state will be the loss of autonomy in setting monetary and fiscal policy. On balance, the microeconomic benefits of the monetary union are not deemed to be all that great and are dwarfed by the concerns surrounding this monetary adventure.
As several witnesses informed the Committee, the introduction of the euro will lead to a number of microeconomic benefits for European countries. Dr. Gunther Albrecht (German Council of Industry and Trade, Bonn) pointed to three expected benefits: a reduction in the transactions costs associated with converting European currencies; a deepening of market integration through a removal of exchange rate volatility and risk as the uncertainty caused by fluctuating exchange rates ceases to exist; and an improvement in price transparency, leading to greater economic competitiveness within the participating countries.
How large will the economic gains be, in terms of GDP savings? While the answer depends on just who is doing the analysis, estimates of savings in transaction costs alone ranged from 0.4% to 1% of the EU’s GDP. Mr. Murray observed that the top end of the range was too high, that the more reasonable yet still significant (in terms of its long-term, cumulative impact on the European economy) low-end estimate of 0.4% would be more appropriate. Pierre Jacquet (Directeur adjoint — Économie, Institut français des relations internationales, Paris) was even more reluctant to attribute considerable economic benefit to the implementation of the euro, arguing that the benefits of market integration from what he perceived to be a minor shift in Europe’s monetary arrangement were "not such a big deal." Both Mr. Murray and Dr. Scheid concurred that the move to the euro did not represent a major shift from the previous managed float system, with the former pointing to the currencies of Austria, Netherlands, and Belgium having been already fixed to the Deutsch mark prior to the launch of the euro. Nevertheless, the introduction of the euro undoubtedly lowers the transactions costs associated with converting currencies.
Second, greater exchange rate stability should lead to higher rates of economic growth. Firms will find it easier to finance investments, and more trade will be generated as exchange rate uncertainty is reduced.
The shift to a single currency should also reveal the true cost of labour and goods throughout Europe, thus making the prices of products more transparent and competitive. Consumers should find it easier to compare prices from country to country for similar or identical products. Adopting the same logic, it should also become easier for Canadian importers to comparison shop on the basis of price.
2. Greater Monetary and Fiscal Stability
Both Ms. Smadja and Mr. Murray highlighted the contribution of the EMU process to the achievement of fiscal and monetary stability in the region. As already mentioned, the period prior to the launch of the euro saw the imposition of significant economic restrictions on many potential member countries. This discipline improved the fiscal position and economic performance of the countries in question — Italy is the oft-cited example of a country that improved its economic standing greatly in its efforts to conform to the conditions set out in the Stability and Growth Pact — and brought about a noticeable convergence in both short- and long-term interest rates. This agreement contains rules for fiscal policy, sets out a procedure for monitoring members’ compliance with the rules, and specifies the sanctions that can be applied against non-performance.
Moreover, countries that have had a history of high rates of inflation (e.g., Italy and Spain) could well benefit from the transfer of monetary authority to the ECB, whose primary objective is, in fact, price stability. The ECB’s initial credibility in terms of its monetary policy exceeds that of the Southern European countries’ central banks.
3. The Euro’s Enhanced International Role
It is anticipated that a rise in the value of the euro over time should lead to the new currency assuming a more significant global role in three important areas: official reserves, international trade, and private financial transactions. In terms of official reserves, the euro is expected to become an increasingly important reserve currency as large reserve holders come to find merit in possessing this new currency for foreign exchange dealings, for trade invoicing purposes, and as a store of value — witness China’s stated intention to convert one-third of its international reserves into euros — eventually perhaps rivalling the U.S. dollar in its reserve function. According to Mr. Jacquet, the move to the euro within international portfolios began in the second half of 1998, in other words considerably before the launch of the new currency. By the first quarter of 1999, the euro already had become the currency of choice in euro-bond markets. More recently, however, there has been some evidence that capital has been drawn out of the euro, as some investors have deserted the falling currency.
Those witnesses expressing a view on the subject of the euro as an additional world reserve currency were unanimous that the creation of such a new reserve currency would generate a more balanced international reserve situation. With the dollar-euro exchange rate becoming increasingly important internationally, it will be in the best interest of both Europe and the United States to achieve reasonable exchange-rate stability. Japan, too, would not want to let its exchange rate diverge too far from the dollar-euro rate. Mr. Murray observed that the introduction of the euro could be of some benefit to Canada in that it could mark the end of U.S. hegemony in monetary matters.
Although not all analysts share this view, EMU proponents anticipate that an increasingly bipolar international monetary system would be characterized by less global monetary instability. A key argument used to defend this point of view is that the fact that Europe is acting as a single player in monetary and exchange rate matters will help strengthen, not weaken, the effectiveness of global economic policy coordination.
Many analysts also expect the euro increasingly to lubricate trade in goods and services, especially given the European region’s importance in international trade ? the euro zone accounts for 18.5% of the world’s trade (excluding intra-EU trade), roughly the same share as that of the U.S. On the other hand, a full 50% of the world’s commercial transactions and 80% of its financial transactions are in dollars. Experts forecast a shift in the situation in favour of the euro. For example, Ms. Smadja pointed to predictions that in the medium-term, a full 35% of global trade may be undertaken in euros. If trade becomes increasingly denominated in euros (at the expense of the U.S. dollar), a greater proportion of foreign exchange reserves will be held in that currency, with the value of the euro rising as a result.
Finally, the euro should continue to help individual investors diversify their portfolios as the currency rebounds in strength. The creation of a single European capital market to replace previously fragmented national markets will help promote such diversification.
4. The EMU as a Springboard to European Economic Reforms
It is beyond question that structural deficiencies in both labour and product markets are much higher in Europe than in the United States (and much higher in continental Europe than in the United Kingdom) and that the pace of European structural reform has been slow. As Jan Host Schmidt (Director, Directorate-General II/B, Economic and Financial Affairs, European Commission, Brussels) suggested to the Committee, the challenge of engaging in structural reform, especially the lowering of social security benefits, is extremely difficult.
Another policy that could use adjustment relates to high minimum wage levels, which, according to Mr. Trichet, have had a devastating impact on unskilled workers. The resulting unemployment causes governments to impose high taxes on productive workers and sectors of the European economy, thus causing a brain drain to occur to other countries (e.g., the U.S. and Ireland).
There is some reason for optimism that economic reforms may be starting. In June, for example, the new German government introduced a program of budget and tax cuts for the economy. This action is the first formal change in what has often been referred to as the "German model." As such, this action has gone against historical tendencies.
EMU proponents often argue that the currency union will accelerate the push for economic reforms (e.g., tax reform, social benefits reform, and labour market reform) within the euro-11 zone. In the words of Mr. Murray, "this is what EMU and the euro were all about." However, the real question is: Which way will the causation work? The Committee heard that reforms need to occur, with or without the euro. We were told that should the necessary reforms be implemented, the result would be a more successful EMU. In other words, the causation could work in the opposite direction, or the effects could be mutually reinforcing.
In view of the absence of national exchange rates, the predominance of the price stability objective of the ECB, and the limited scope for fiscal policy under the EMU’s Stability and Growth Pact, many observers have predicted that governments in European countries will enhance the flexibility of their countries’ labour markets so as to reduce unemployment and regional disparities. According to Mr. Murray little evidence of this structural adjustment had been noticed as of the end of April; yet it must be recognized that normally it takes considerably more time for such an adjustment to occur.
Many other experts whose views the Committee canvassed supported the need for structural reform. Mr. de Boissieu called for structural reforms in the area of the labour market and taxation, arguing that the current tax system is unsustainable. He appeared to be confident that the establishment of the EMU would force changes to both taxation ? he advocates a reduction in marginal tax rates ? and spending policies. In other words, the disciplines led by EMU would lead to a more “rigorous” fiscal policy.
Dr. Albrecht suggested that the EMU would lead to a greater convergence of policies on labour markets. Also, he advocates a change in fiscal policy in Europe, specifically reductions in tax rates as part of an overall corporate tax reform.
Gunter Grosche (Director, Directorate-General II, Economic and Financial Affairs, European Commission, Brussels) concurred that structural reforms have to be achieved, starting with the continent’s generous social security program. According to Mr. Grosche, the EU, while not having a major direct impact on members’ fiscal policies, is attempting to create pressure on member countries to reduce government expenditures.
The competing point of view is that the EMU has not proven to be a remarkable event, and that there is pressure on individual European governments to undertake economic reforms, euro or no euro. In Paris, Mr. Jacquet viewed the essential problem of Europe as comprising three elements: high unemployment, structural problems, and a lack of innovation. He firmly believes that the EMU is a necessary but not a sufficient condition in that, while the euro is a positive development and could help speed up structural reform, it will not cure Europe’s fundamental problem on its own. What is urgently needed, he argued, is the implementation of a large-scale tax cut in the form of a low-rate flat tax, in combination with a drastic reduction in public spending (e.g., in Germany’s generous social system/safety net) and deregulation of European labour and goods markets. According to Mr. Jacquet, optimally the reform effort would be performed at the EU level. Owing to Europe’s traditional timidity when it comes to reforms, he is not highly confident that this reform effort will materialize.
Dr. Manfred Neumann (Professor, Institute for International and Political Economy, Bonn) also argued the other side of the equation, that the EMU itself would work better if the governments would implement more deregulation of goods markets and labour markets. This, he contended, is the real problem facing Europe. In Germany, for instance, the existence of powerful labour interests restricts the unemployment rate from falling. He advocates reductions in tax rates, reform of social benefits, introduction of a negative income tax to subsidize new employment in the low wage area, as well as a deregulation of labour markets to reduce labour-market rigidities. He is hopeful that tax reform and pension reform will take place, but does not see anything in the works as far as labour market reform is concerned. Dr. Neumann does not view the situation in Italy and France as being much better. Lack of progress in removing labour-market rigidities has three unfortunate consequences: it constrains improvements in the domestic unemployment situation; it harms Europe’s competitive position with North America, whose labour markets show considerably greater flexibility; and it keeps the EMU from functioning better.
C. EMU Concerns and Challenges
1. Is the EMU an "Optimum Currency Area"?
It has often been argued that the 11 countries that make up the EMU do not constitute an "optimum currency area," in that they do not possess a number of vital preconditions such as similar economies and business cycles. The countries whose currencies are being linked have different languages, different customs, and different economic structures brought about by the countries’ contrasting levels of development. Moreover, they are at different stages of the business cycle. Therefore, they require rather different monetary policies. Most importantly, whether the move to a common currency arrangement is a good or bad idea depends mainly on the adjustment mechanisms that are available to absorb shocks that impinge differentially on the various entities within the currency union. In Europe, regrettably, goods and capital move less freely than they ought to within a currency union, and the political structure is not set up to cushion such shocks. The real danger is that the single currency will exacerbate rather than soothe political tensions by converting divergent shocks, which under the old monetary arrangement could have been readily accommodated by exchange-rate changes, into divisive political issues.
The first precondition for a workable monetary union is that the EMU member states possess similar economies. If an external shock were to strike a particular economic sector in one country in a certain way, the effects would be similar in other countries. In that ideal situation, each country would require the same exchange-rate adjustment.
A second precondition is that it would be helpful if the economic cycles of the countries forming the monetary union were similar. In Europe, significant convergence was achieved in exchange rates, inflation rates, interest rates, and government finances before the euro came in, thanks in part to the Stability and Growth Pact. However, economic structures remain distinct and some of the success achieved in converging the various economies has now worn off. After a period in which the indicators for the 11 euro-economies were pointing in the same direction, individual growth rates have begun to differ. Countries on the fringes of Europe (e.g., Ireland and Finland) are now performing at a superior level (growth rates of between 8 and 10%) than those in the core (e.g., Germany and France). Countries in the latter group could use more stimulus since they have not yet reached full employment, while those in the former already are encountering inflationary pressures and do not require an accommodating monetary policy.
Variation in growth rates suggest that last year’s international economic turmoil may have created an asymmetric shock for the euro-11 zone, one that affected Germany more than the rest. Research done on the "optimum currency area" has revealed that restricting exchange rate flexibility may not be useful when countries are affected differently by the same economic shocks. Mr. Murray was of the view that imposing a "one-size-fits-all" monetary policy on such a mix of countries may therefore not end up fitting everyone, with the smaller countries on the periphery likely to fare worse than the economically more powerful core ones. If these countries find that as a result of the loss of monetary sovereignty, they cannot achieve their economic and social objectives, they may become disillusioned. The Committee is of the view that it will be an ongoing challenge for the new European Central Bank to create a single monetary policy suitable for all the eleven countries participating in EMU.
The precondition of a convergence of business cycles is important since monetary policy under a monetary union such as the EMU cannot respond to country-specific or regional shocks. When outside economic shocks do arise, their impacts are often felt asymmetrically. For countries outside a monetary union, this should not pose a problem as exchange rate flexibility can deal with such shocks. Inside the EMU, on the other hand, a substantial degree of business-cycle convergence would be highly desirable. As Dr. Manfred Neumann noted, if all economies in the union had the same business cycle, then the ECB could afford to use monetary policy as a stabilization tool. However, the divergence in economic growth rates throughout the region tends to cause the ECB to conduct a more cautious monetary policy.
While the same arguments can be levied with respect to monetary unions within countries such as the United States and Canada (e.g., the situation in Alberta compared with the situation in Ontario), these countries have important adjustment mechanisms that are simply unavailable in the European case. For example, a contraction in forest product prices will affect the Finnish economy in a different manner than it would that of Germany. Since wages and prices are inflexible in Europe, and there are few signs that the euro member countries are reforming their labour markets significantly, since labour is relatively immobile (i.e., there would be no mass movement of unemployed Finnish workers away from Finland to countries where job prospects are greater), and since the limited EU budget precludes large-scale government transfers within the euro-11 set of countries, membership in the monetary union would likely cause Finland to experience greater economic pain when external economic shocks arise ? as inevitably they will ? than it otherwise would have.
The crucial point with respect to monetary unions such as the EMU, is that, in the absence of flexible exchange rates, there must be flexibility elsewhere, such as labour market flexibility or mobility. However, as Stéphanie Guichard (Centre d’études prospectives et d’informations internationales, Paris) observed in her detailed comments on asymmetry and the problems this may cause for the monetary union, labour markets in Europe are extremely heterogeneous. Regrettably, Europe suffers from deep-rooted labour market imperfections and structural rigidities, as opposed to the U.S. and Canada where labour markets, wages, and prices are far more flexible. A common European monetary policy therefore has two strikes against it: first, it must fit both a diverse group; and, second, it cannot depend on the safety valve of labour market adjustment.
In the absence of both flexibility of floating exchange rates and labour market mobility, countries experiencing adverse economic shocks are forced to conduct counter-cyclical fiscal policy. Fiscal adjustments are up to each member government, since the EU’s existing programs are insufficient in scope to deal with unemployment problems that may arise as a result of the move to the single currency. The trouble is that Europe’s fiscal room is limited owing to the constraints imposed by the Stability and Growth Pact, so that such a strategy would be tough to implement. Many have argued that this agreement has tied the hands of governments to deal with future economic difficulties through fiscal means, thereby giving the governments of participating countries a reason to put all the blame for any economic malaise on the euro and the ECB. The contrary view is that one has to keep the fiscal policies of member countries converging, by placing pressure on countries to remain fiscally in step.
Yet another key EMU shortcoming is the lack of an accompanying centralized political and fiscal authority that would encompass a large centralized fiscal transfer system at the EU level. According to Mr. Murray, the prospects of a successful EMU would be far better if there were a central government in Europe that would plan and coordinate fiscal policy.
Responding to a Committee member’s views on this point, Mr. Saunders countered that the relevant question is whether one thinks that greater political authority is good. For his part, Mr. Trichet attempted to counter criticism of the absence of a centralized federal budget in Europe by pointing out that it was precisely because of the lack of a political system that a Stability and Growth Pact, complete with sanctions and fines for non-performers, was introduced. Mr. Trichet observed that the ability of the EU to bring its members back into line gives the institution more influence on the individual member governments than does, for example, Washington (D.C.) on California. He also argued that stabilization budgets were enshrined in the Maastricht Treaty so as to build in compensation for asymmetric shocks.
The Committee understands that the rationale for the EMU was largely political rather than economic in nature. Nevertheless, it appears that Europe has a fundamental problem in that the EU brought in an EMU without ensuring that the above-mentioned preconditions were in place. In retrospect, probably it would have been better to have waited until the structures of the participating economies were more closely aligned and the necessary adjustment mechanisms to deal with these economic shocks were in place. It is not clear how member countries will react to asymmetric economic shocks, should they occur, without these necessary adjustment tools in place. It seems obvious that structural reform must happen to enable these adjustment processes to work (and that the convergence process must be maintained). Up to now, the willingness to undertake these reforms, especially in labour markets, seems to have been less than adequate.
2. The Independence of the European Central Bank
Will the ECB be able to maintain the independence that will be necessary if it is to satisfy the international financial community’s requirement, as well as its own internal mandate, for sound monetary policy leading to price stability? With no central government in Europe, and with the Maastrich Treaty providing that the ECB is not to be controlled politically by EMU member governments, the ECB has almost absolute independence in terms of the monetary goals and instruments that it employs. Mr. Murray noted that this independence has been preserved through legislation so that the Bank can be successful in achieving its long-term monetary policies. According to a number of the European witnesses heard by the Committee, the Bank’s independence has not been jeopardized by recent developments (e.g., the strengthening of the European Parliament).
It remains to be seen precisely what the respective roles of the Euro-11 Council (incorporating the finance ministers of the eleven participating states) and the central bank will be. For the moment, there continues to be a risk of tension between the Euro-11 Council and the management of the ECB on monetary policy.
Will the Bank be able to withstand strong political pressure from various European governments hit by severe economic downturns? Since the launch of the euro in January 1999, frustration has arisen with respect to the way monetary policy has been conducted ? the ECB should have eased the monetary situation earlier than it did in the spring ? and politicians’ inability to influence the central bank.
Independence and accountability are two quite distinct issues, however. The Maastricht treaty provides for no clear accountability of the ECB to any other body. The ECB currently attempts to engage in disclosure to European institutions, by presenting an annual report to the European Parliament and by appearing four times a year before a committee of that Parliament. Moreover, the Council of Ministers for Economic Affairs and Finance (ECOFIN), the body that monitors the Stability and Growth Pact and that ensures the coordination of EU member countries’ economic policies, is free to observe the ECB’s own meetings.
Should your Committee be concerned that the powers of the new central bank will increase the existing EU "democratic deficit"? As Parliamentarians, we believe that it is indeed fortunate that recently the European Parliament has begun to take on a more proactive role regarding the policies of the ECB, having some of its officials appear before it to explain the policies and positions that the Bank has taken. Certainly, there is some value in ensuring even greater accountability on the part of the Bank. However, it can be argued that making the ECB more accountable should not come at the expense of the central bank’s operational independence.
3. The ECB’s Principal Mandate
The Committee received contrasting evidence on the primary mandate of the ECB. Dr. Scheid, an official of the Bank, noted that ECB monetary strategy is based on two objectives: first, the Bank’s principal objective of price stability as part of a set of economic indicators; and, second, monetary growth, in which an attempt is made to meet a pre-established reference value over a one-year period. He informed Committee members that the ECB does not have an explicit exchange rate target; exchange-rate issues are less important than under the previous monetary arrangement and such a target might conflict with the price stability mandate. In turn, the price stability target has been defined as the attainment of inflation of less than 2% in the euro-11 zone as a whole. With inflation running at 1.1%, it is felt that the price stability objective had been met.
On the other hand, Dr. Manfred Neumann, a self-avowed Euroskeptic, was not at all clear what the ECB had in mind in terms of its medium-term monetary policy. He claimed that there was no rule in place that private interests could use in making plans and predictions. Nor did he feel confident that the Bank had been undertaking a consistent monetary policy: even though money growth (M3 = 5.1%) had been exceeding the ECB’s reference value (M3 = 4.5%), the monetary authorities had lowered interest rates. He supported explicit goals of price stability, in keeping with historical German objectives.
Is the ECB’s price stability objective too restrictive? Critics of ECB policies have argued that the Bank should not be so single-minded in its objectives, and that it should take into account the wider economic repercussions of its anti-inflation policies. Also, critics have contended that it is also important that all countries in the EMU share the same economic culture of price stability. If they do not, the actions taken by the ECB may result in conflicts among member countries and a reduction in public support for the monetary union.
A final issue to raise, and one that did arise during the Committee’s European fact-finding mission, is the role of the ECB as the lender of last resort. Mr. Jacquet informed the Committee that the Bank will not be undertaking this role, but will rely on the assistance promised by national governments in the event of major European banking crises. It remains to be seen whether the necessary financial support will materialize. Mr. de Boisseiu disagreed with this assessment, arguing that the ECB will have no choice but to play the role of designated lender of last resort.
4. Potential for Greater Exchange-Rate and Trade Meddling
Concern was expressed, both to and by Committee members, about the increased risk of a unified bloc such as the EMU meddling on the international stage. While far from worried about the economic effects of the shift to the euro, Mr. Murray told us that there is a real possibility that the danger of European political intervention in exchange-rate and trade matters had risen. Regarding currency manipulation, he claimed that there continues to be interest within Europe in establishing target rates or bands for the world’s major currencies ? the U.S. dollar, the euro, and the yen ? a managed exchange-rate development which, he reasoned, would not be in Canada’s best interests. On the other hand, support for such an approach ? the establishment of rates or bands ? in North America was much less in evidence, with both the Canadian and U.S. authorities not supporting the adoption of target zones or any forms of intervention.
Inevitably, the subject of a "Fortress Europe" came up during the Committee’s European mission. Several witnesses expressed optimism that the establishment of the EMU would not lead to a tighter closed-door trade policy in the long run, even though it was acknowledged that Europe was currently preoccupied with internal matters and that intra-EMU trade would rise slightly in the short-term. Most witnesses with a view on this issue were absolutely convinced that turning inwards would be counterproductive for the long-term interests of Europe.
5. Impact on Europe’s Financial Sector
Europe has long been known for its inefficient and fragmented banking system. As Mr. de Boissieu told the Committee, the strong forces of globalization and deregulation eventually would have unleashed a powerful wave of financial-sector reorganization, regardless of whether an EMU had been created or not. However, several witnesses noted that the EMU already had succeeded in accelerating the modest steps that were beginning to be made towards a shakeup in European banking; moreover, it would already appear that Europe’s previously fragmented bond and stock markets have become more integrated and liquid much more quickly than anticipated, resulting in reduced costs for business financing. Dr. Wolfgang Neumann (Deutscher Sparkassen - und Giroverband e. V., Bonn) was of this opinion. He predicted a number of key effects of the EMU on the financial services industry: even bigger mergers and more acquisition activity, stronger segmentation of the industry as national markets vanish, and an integration of equity markets throughout Europe.
Mr. Murray argued that while such a restructuring would bring important benefits to European consumers in the long run, it also could impose serious losses in the form of unemployment and financial instability during the transition period. Indeed, with the level of bank restructuring and rationalization in Europe currently being especially strong, a period of substantive volatility in financial markets had already been experienced. Also, Mr. de Boissieu expressed his concern for excessive corporate concentration in the banking sector, arguing that the intense merger activity eventually could lead to the introduction of anti-trust policy.
The current British government under Tony Blair has expressed its support, in principle, for joining a "successful" euro, but such action will take place only after five criteria ((1) the convergence of business cycles in the UK and EMU countries; (2) an increase in labour-market flexibility; (3) improved investment in the U.K. as a result of the EMU; (4) benefits accruing to the UK financial sector from the EMU; and (5) a positive impact of the EMU on growth and employment) are met and a referendum has been held after the next general election. In February of this year, the government made public "a national changeover plan" for replacing the pound with the euro as the United Kingdom’s currency.
Since then, however, the U.K. public’s appetite for membership in the EMU seems to have declined further. Evidence of this change in opinion appeared in the results of the June election of the European Parliament, in which parties opposed to joining the monetary union registered considerable success. It is now not clear when the proposed referendum will occur ? certainly the state of public opinion will be a major determining factor. What is obvious at this point is that a large-scale political battle over the membership question is taking shape in the U.K. To attempt to influence voter sentiment in favour of entry, Mr. Blair has fashioned a coalition of major political leaders from Britain’s three largest parties (i.e., Labour, Conservative, and Liberal Democrat).
While in Europe, the Committee heard strong arguments from the Right Honourable Lord Owen against membership. He put forward the following points:
- The United Kingdom had already participated in three continental monetary arrangements, none of which proved durable, and had no appetite for a fourth such venture.
- A move to a monetary union with continental Europe would entail giving up sovereignty over monetary policy at a time when the Bank of England is performing well in terms of ensuring monetary stability and keeping the inflation rate down.
- The U.K.’s business cycle is out of step with that of continental Europe; consequently, the U.K. is not a good candidate for entry. For the euro-11 zone to be viewed as an "optimum currency area," member countries should possess similar economies and display similar business cycles. That way, when outside economic shocks do arise, their impacts are felt in a similar way by each country. A "one monetary policy fits all" approach probably would not be beneficial for the U.K.
- Without exchange rate flexibility to absorb economic disturbances and without labour market mobility to reduce unemployment and regional disparities, governments will have to rely on fiscal transfers to help those requiring assistance. However, such transfers are coming under downward pressure.
- Currency unions inevitably lead to political unions.
- He is concerned that the U.K.’s entry into the EMU would lead to greater regulation of the City, thereby nullifying its competitive advantage.
As these points suggest, there are sound economic arguments against Britain’s entry at this time. Notwithstanding these arguments, both the current advantages of remaining outside the EMU and the fact that U.K. economic growth has been favourable outside the EMU, a number of witnesses expressed the view that eventually the U.K. would join. Mr. Saunders observed that the U.K. could remain outside for the next ten to fifteen years, but not forever. Rising political support for the monetary union would certainly hasten the decision, he noted. Mr. de Boisseu reckoned that entry would occur sometime in the 2003-4 period, reasoning that when it is seen that the euro works well, the U.K. will prefer to be in rather than out. Indeed, there is no doubt that British influence in EMU policy-making would be limited if the U.K. remains an outsider. For his part, Dr. Manfred Neumann pointed out that London could lose some of its European-leading financial activity to Frankfurt, and argued that economically it would be to the U.K.’s advantage to join, as long as the inflation rate within Euroland was not excessive (i.e., not above 4%). Both Mr. Murray and Mr. Grosche also thought that eventually the U.K. will join.
D. Implications of EMU for Canada
This Committee’s 1996 European report identified several implications for Canada of the new single currency: the potential effects of EMU on the exchange rate of the Canadian dollar, on trade and investment patterns between Canada and the EU, and on the balance of power in international economic policy coordination fora such as the G-7. Regarding the former, Mr. Murray observed that in the first four months after the launch of the euro, the Canadian dollar had not suffered because of the new currency.
Canada’s trade with EMU members accounts for a relatively small share of its total trade (our trade with the entire EU accounts for only 8-9% of the total), and, according to Mr. Murray, it seems likely that our trade will increasingly become hemispheric in nature. The direct impact of developments in the euro area is expected to be limited.
Nevertheless, the EMU and European integration are expected to have a positive effect on countries such as Canada because the single currency and the integrated market will remove the costs related to currency transactions and exchange rate risks, thereby facilitating financial and business transactions. Moreover, if gains in productivity, investment, and incomes are achieved in Europe in the longer term because of EMU and the European structural reforms that the EMU may prompt, the forces of "trade creation" could be of benefit to an open economy such as Canada (i.e., the demand for our exports could rise).
The opposing viewpoint is that if Europe were to experience stagnation following the introduction of the new currency ? perhaps as a result of excessively tight monetary and fiscal policies and the continuation of labour market rigidities ? trade prospects could deteriorate and the potential for new forms of protectionism could arise ? the so-called “Fortress Europe” mentality. At this point, it is still not clear what the net effect of the EMU on Canada will be.
So, in the short term at least, the EMU is not expected to exert much of a direct trade and investment impact on Canada. The same can not be said about the implication of the EMU for the future of North American monetary arrangements, which is a far bigger question for Canada. The introduction of the single currency already has led to renewed interest in a common currency with the U.S.A. Already, a debate has been launched in the Senate, Canadian academic circles, and elsewhere, on the merits of alternative currency arrangements for North America. According to Mr. Murray, interest has been sparked by three things: the euro’s demonstration effect, the dramatic long-term decline of the Canadian dollar versus the U.S. dollar, and the recent interest in "dollarization" (adoption of the U.S. currency as legal tender) by countries such as Argentina and Mexico. One can surely add to this list the increasing integration of the Canadian and American economies which has occurred in recent years.
Notwithstanding the fact that the North American situation is quite different from that of Europe, lessons can be learned from the EMU. Foremost is the need to have the right "winning conditions" in place; these are simply not yet there in the case of Europe. Another key point is that Canadians should give priority to the economic benefits of such a move and ensure that total sovereignty is not abandoned; unlike many European politicians, Canadians are not interested in a political union.
Can any parallels be drawn between monetary developments in Europe and the situation in North America? We see the two situations as very different. As was mentioned above, Europe opted for monetary union to enhance political integration, whereas Canada does not want political union with its southern neighbour. For Canadians what should be weighed are the economic consequences of such a move.
Second, compared with that of the United States, the Canadian economy is small. Therefore, it would enjoy little, if any, influence over monetary policy in any new North American monetary setup. By entering into a monetary union with the United States, Canada would lose its ability to engage in an independent monetary policy, a policy that has been carried out reasonably effectively in recent years. In other words, monetary sovereignty would be lost.
Perhaps most importantly, Europe did not attempt to ensure that all the prerequisites of an "optimum currency area" were in place before launching this "grand experiment." As a result the EMU is not a "crowning touch" but rather a spur to change. In Canada, on the other hand, the debate appears to be clearly focused on the economic logic of a currency union with the U.S.
There is no need for Canada to rush to a decision on a North American monetary union. Even if at first glance a monetary union might seem to make sense given the openness of the Canadian economy and its dependence on Canada-U.S. trade, it is important to take the time to ensure that the preconditions are in place. Currently, Canada’s economy is much more vulnerable to outside shocks than that of the U.S., with differences in the industrial structure (i.e., dependence on commodities) and the degree of specialization being key explanatory variables. Canadian and U.S. terms of trade ? the ratio of export to import prices ? are affected differently during periods when significant changes in world commodity prices occur.
Right now, the "winning conditions" for an optimum currency area on this continent (Canada and U.S. at similar points in the business cycle and displaying similar economic structures; sufficient labour market flexibility; a fiscal transfer system at the North American level) are certainly not yet in place. As even the Governor of the Bank of Canada has been heard to say, perhaps some day the concept will make more economic sense. The Committee therefore recommends:
Recommendation 1: That no common currency arrangement with the United States be entered into by the federal government without it having concrete evidence that the required pre-conditions of an "optimum currency area" are in place. |
The new European monetary arrangement may have consequences for Canada’s influence on the international scene (e.g., G-7 membership). In the long run, Canada’s status on the world stage and, more specifically, during discussions on the management of monetary issues in the international financial system, could diminish as the world comes to be dominated by three large economic blocs (U.S., EU, Japan) and forms a G3. The Committee is concerned that Canada not lose its influence in international economic affairs. Accordingly, it recommends:
Recommendation 2: That Canada continuously strive to maintain its current standing and level of influence as a member of various international organizations such as the G-7 group of countries. Any lessening of Canada’s influence on international monetary and broader economic issues, owing to a potential movement to a tri-polar (or any other) global currency environment, should be actively resisted. |
Finally, several other possible effects should be mentioned. First, as the European financial sector restructures, pressure will be exerted on Canadian banks to consolidate and merge. A perception is now in place that Canada has gone against the global merger trend. Second, if fiscal policy in Europe is constrained, if labour markets continue to be rigid, and if the flexibility of an independent monetary policy is missing, then Europe’s policy options will become limited and a return to protectionism could be in the cards (e.g., the bananas dispute, the beef problem). The international economic community, including Canada, would not be well served if the EMU were to foster an even more ardent "Fortress Europe" mentality.