QUICK FACTS Glossary of EU Terms Comparative Statistics RELATED ARTICLES "The European System of Central Banks," Economic Review, First Quarter 1999 (Text or PDF) "European Economic and Monetary Union," Hot Topics May 1998 (PDF) "Europe: Risk and Reward Under Monetary Unification," Southwest Economy Nov./Dec. 1998 (Text or PDF)

Global Economy
European Economic and Monetary Union (EMU)

Dallas Fed Economist Mark Wynne explores the implications of this unprecedented monetary union.

• How will EMU affect the United States?
• How will the euro affect the dollar's global role?
• How does the European System of Central Banks (ESCB) differ from the Federal Reserve System?
• Is Europe an optimum currency area? A Texas analogy

How will EMU affect the United States?
Given the degree of uncertainty about how monetary union will affect Europe, it should not be too surprising that there is relatively little that we can say with any precision about how EMU will affect the United States. Ultimately, EMU may end up teaching us more about economics than economics can currently teach us about EMU.

One of the most immediate effects of EMU will be to accelerate the development of the single market in Europe and make it a lot easier for U.S. corporations to do business there. Instead of having to worry about 11 different currencies, there will be only one currency for an area that will account for about one-fifth of world output and about one-fifth of world trade as well. The single market will be enhanced by greater transparency in pricing, which some commentators believe will foster greater competition across the EU and ultimately breed stronger industrial and commercial enterprises. The creation of a single capital market will also address one of the greatest problems small companies in Europe have faced in trying to grow and develop.

How will the euro affect the dollar's global role?
In the longer run, the success of the euro may pose a challenge to the international role of the dollar. A credible euro could be an attractive alternative to the dollar as a vehicle currency for international transactions and as a reserve currency, and this could create interesting problems in the area of monetary control for the Federal Reserve System. As with everything else in this debate, whether and how soon the euro is likely to challenge the dollar as the world's major reserve currency is subject to a lot of uncertainty. In one camp there are those who argue that the forces of inertia favor continued use of the dollar for a long time to come. On the other hand, there are the euro-enthusiasts who believe that the euro could come to rival or even replace the dollar in as little as five years. And in the middle are those who argue that it is simply too soon to tell whether the euro has this potential. A lot depends on how successful the ECB is at managing the difficult first years. Perhaps the most plausible scenario is that eventually the euro will come to play Airbus to the dollar's Boeing.

Parenthetically, I might note that one area where the euro may pose a serious challenge to the dollar is as the currency of choice for the underground economy. As you know, the highest denomination note issued by the Federal Reserve System is the $100 bill. The planned denominations of euro notes include a 500 euro note, worth about $550 at current exchange rates. Some academic economists have drawn attention to the attractiveness of the high-denomination euro notes for illicit transactions, and argued that the existence of these denominations will make the euro more attractive that the dollar for these purposes. Insofar as the euro does succeed in this regard, there would be a loss of seigniorage income for the United States, but the exact amount (or even the order of magnitude) is anybody's guess.

How does the European System of Central Banks (ESCB) differ from the Federal Reserve System?
There are two key differences between the ESCB and the Federal Reserve System. First, the ESCB has a much stronger price stability mandate. Second, power is much more diffusely distributed in the ESCB. The strong mandate for price stability will enhance the euro's credibility. But the diffuse power structure may make it difficult to resolve conflicts, which will undermine credibility. The monetary union's fate depends on which of these two features of the monetary policy process dominates.

For a more detailed comparison of the ESCB with the Federal Reserve System, see "The European System of Central Banks" in Economic Review, First Quarter 1999 (PDF).

Is Europe an optimum currency area? A Texas analogy
Since EMU was first proposed, there has been no shortage of academic critics pointing out the dangers of such an undertaking. In the United States two of the most prominent critics have been Martin Feldstein of Harvard University and Milton Friedman of Stanford University. The essential point made by most of the critics is that Europe as a whole does not constitute what economists refer to as an optimum currency area.

The theory of optimum currency areas establishes the conditions under which a group of countries (or regions within a country) may share a single currency without incurring problems as a result. The reason sharing a common currency may be costly is that it deprives states of the ability to alter the nominal exchange rate of their currency in response to a shock. The United States is often cited as an example of an optimum currency area. There are many ways of dividing the United States into regions, but one particularly relevant division is into the 12 Federal Reserve Districts. The dollar bills bearing the seals of the 12 regional banks can be viewed as 12 separate currencies that exchange for one another at permanently fixed exchange rates, much as the exchange rate between the French franc and the Deutsche mark will be irrevocably fixed on January 1, 1999.

Consider what the options were for Texas when oil prices collapsed in 1986. One option would have been to simply devalue the Dallas or Texas dollar, making Texas' exports cheaper, thereby mitigating the adverse effects of the shock on the Texas economy. Of course, this is not an option because Texas is bound irrevocably in a monetary (and political) union with the rest of the United States. Thus, the way the 1986 oil price shock was handled was through out-migration and wage declines: unemployed workers simply upped and went to where the jobs were, and those who remained saw their wages grow less rapidly than in the rest of the United States. This is how regions in the United States typically deal with shocks, whether the rust belt of the Upper Midwest in the early 1980s, Texas in the mid 1980s, or California and New England in the early 1990s. The other key mechanism whereby regional shocks are mitigated in the United States is via transfers from the federal government (in the form of unemployment benefits and lower income taxes).

It is the fact that unemployed workers can so easily relocate to different parts of the United States, and the fact that wages are flexible, that makes many economists believe that the United States is an optimum currency area. It is precisely because the migration option is not so freely available in Europe, and wages are a lot less flexible, that makes retention of the nominal exchange rate a potentially important tool for handling shocks. There are a variety of features of the labor and housing markets in Europe that make migration difficult. In addition, there the barriers of language and culture, which are more difficult to overcome. Nor is there a large central government at the European level that can make transfers to distressed regions to help them overcome transitory shocks.

The theory of optimum currency areas is one of the few tools available to economists for assessing the viability of EMU. However, despite the magnitude of the undertaking that EMU represents, the theory has evolved little since its original articulation in the early 1960s. To start with, the theory is predicated on the assumption that changes in the nominal exchange rate have real effects, a notion that has been challenged by some economists in recent years. More significantly, the architect of the theory of optimum currency areas, Robert Mundell, recently pointed out in a series of articles in the Wall Street Journal that a policy of devaluation in response to adverse shocks cannot work indefinitely. While a surprise devaluation may work once or twice, as soon as workers and investors come to anticipate the use of devaluation as a tool for dealing with shocks, the tool will lose its effectiveness.

There is also the more substantive fact that the pre-monetary union behavior of both the public and private sectors is a bad predictor of their behavior once the monetary union is in place. EMU constitutes a regime change for monetary policy in Europe, and one thing modern macroeconomics teaches is that the behavior of workers and investors will change when the policy regime changes. Just as we cannot expect to be able to predict the behavior of a football player following a change in the rules of the game by simply looking to his past behavior, so too is it difficult to predict what will happen when the monetary rules of the game change in Europe.

For more information, read "European Economic and Monetary Union, In Depth, May 1998" (PDF).

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