Transcript of an Economic Forum - The Euro: Ready or Not

January 10, 2002

International Monetary Fund
Multipurpose Room, B-702
Thursday, January 10, 2002
Washington, D.C.

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Michael Deppler (Moderator), Director, IMF European I Department

Gerard Baker, Financial Times

Moreno Bertoldi, Economic and Financial Counselor, European Union

Gerald Grisse, Permanent Representative, European Central Bank

C. Randall Henning, School of International Service, American University


MR. STARRELS: I'm John Starrels of the External Relations Department, and we're delighted to see all of you here for what promises to be a very substantive and lively event on "The Euro: Ready or Not." Before we begin, I'd like to do dispose of a few house keeping items.

First of all, please avail yourselves of the two documents that we have made available to you at the door.

Secondly, we very much want to see you again, and in that spirit please leave your [business] card or a signature with us.

Finally, we do expect, indeed we want, questions. For this purpose, you'll notice next to your seat a microphone that is activiated by pressing the button down. When you do so, please introduce yourself and, if you think it's appropriate, provide us with your institutional affiliation.

Okay. With that, I have the pleasure and privilege of turning the forum over to Mr. Deppler. Michael, the floor is yours.

MR. DEPPLER: Good morning, and welcome. My name is Michael Deppler. I'm the Director of the European I Department. We've been following the euro project since its inception, which certainly can be viewed as going back maybe as far as the '70s, if not earlier.

Today's Forum is quite topical. As you know, the euro has been on the front page of virtually all of the world's press for the past few days, celebrating really sort of a rather unique event in monetary history; that is, the changeover from 12 individual national currencies to one common euro currency.

I think everybody would reckon that this has been a huge success. Technically, there have been no glitches. But not only in a technical sense. To outside observers it's interesting to see the extent of popular support for this changeover, as suggested by people's eagerness to switch, which has also dominated the front pages.

Unfortunately, the euro project is not just a matter of putting a new currency into circulation. Fundamentally, the issue is one of whether the euro area can achieve high and growing living standards and employment opportunities for all of its people.

The record there is still mixed, and I'm sure that the panelists today will be addressing both facets of these issues.

The panel is eminently qualified to deal with this subject, and they also come at it from different points of view. I'll give the floor first to what I would describe as the continental/official views: in the first instance, Mr. Grisse, who is the observer in the Fund for the ECB, the European Central Bank, and then to Mr. Bertoldi, who is with the Delegation Of the European Commission in Washington. Then I will turn to the quasi private sector, more Anglo-Saxon members of the panel, in particular, Mr. Henning,from American University, and Mr. Baker from the Financial Times.

Mr. Grisse, the floor is yours.

MR. GRISSE: Thank you very much, Michael. I'm happy to be here this morning, although the title of this forum, "The Euro: Ready or Not," seems to me a little outdated. From our point of view, the euro is ready. Here it is. And it is coming even in two colors, and the bank notes are coming in a state-of-the-art fashion. So if you compare them to other bank notes, I guess they cope reasonably well.

In my remarks today, I should like to focus on two special issues, and that is the cash changeover that is right now going on and the role of the European Central Bank's monetary policy strategy.

The first ten days of the introduction of the euro bank notes and coins have been an impressive success so far for the new money. When you have been in Germany, for example, mid-December, you could see that people queued up in the middle of the night to purchase as soon as possible their so-called starter kits of coins. We have never seen that, and especially the Germans, who always are a little bit skeptical and wanted to stick to their own money, obviously were much more impressed by the new money than everybody would have thought.

Both the acceptance by the 300 million Europeans sharing the euro and the achievements of logistical targets have surpassed all expectations so far.

At the beginning of this week, already about half of the cash transactions in the euro area were conducted in euro, and by Saturday, according to the monitoring that is going on in the European Central Bank, we expect that almost all cash transactions will already be conducted in the new currency. All the existing 200,000 automatic teller machines in the euro area have already been successfully converted.

To share a few more figures with you, the introduction of the euro represented an unprecedented task of putting into circulation some 9 billion bank notes and over 51 billion euro coins. Of these 9 billion euro bank notes, roughly 6.5 billion had been what we call front-loaded to the banks in the euro area by the end of 2001. Outside the euro area, the front-loading to 26 national central banks and credit institutions had started on December 1st.

And, in parallel, inside the euro area the return of the old currencies to the central banks has been increasing day after day, so that the period of effective dual circulation of two currencies is much, much shorter than expected. In most countries, this period was expected to last more or less two months, and so far, what we see so far is that we only need about one week to complete it.

Now, nevertheless, as you know, Europeans sometimes still tend to be skeptics, and there were, for example, reports that the euro 10 note contained a poisonous substance. But I can assure you that all this has been checked, and the bank notes are safe. In fact, in this case it turned out that if you eat more than 400 euro 10 notes, then this could be dangerous for your health.


MR. GRISSE: So I would recommend to you not to eat too much of these euro bank notes.

The introduction of the euro notes and coins represents the ultimate step in the process of European monetary union. In fact, the euro was already launched three years ago when the exchange rates in the euro area were irreversibly fixed.

In the course of the past three years, the ECB has clearly demonstrated that it can achieve its main objective of ensuring price stability. Regarding a possible impact of the changeover on inflation, we have not witnessed, so far, a change in the pricing policy of retailers as a whole. There has been some anecdotal evidence of some specific price increases, but according to our calculations in the European Central Bank, the impact on inflation should be extremely limited.

We think this is largely due to increased competition in the retail sector, to continued awareness of consumers, and the commitment of all governments not to increase the level of administrative prices. All in all, headline inflation is currently around 2 percent, and it should fall safely below 2 percent this year.

This leads me to my second point. As the ECB has designed the monetary policy strategy to maintain price stability in the euro area—and this is our primary objective, and we define price stability as headline inflation below 2 percent. That is certainly a kind of ambitious objective. Since no central bank can fully control price development in the short run, since it takes time for monetary policy action to feed through the economic system, we have formulated our objective in the medium run to maintain a stable price level over the medium term.

To achieve this, our strategy rests on an assessment of two pillars, what we call two pillars. The one pillar is the prominent role we attach to the importance of monetary growth in the euro area economy, and we have formulated this in terms of reference value for M3. And the second pillar comprises a broad assessment of future price developments using a wide range of economic indicators such as wages, exchange rates, long-term interest rates, fiscal policy indicators, and business and consumer surveys.

At this point I would like to stress that the ECB Governing Council has chosen the monetary policy strategy which ensures as much continuity as possible with the strategies pursued by the national central banks prior to monetary union. The ECB's monetary policy strategy is more than a result of an ad hoc decision at the beginning of this new currency area. It is, in fact, a result of a decade-long discussion among European central bankers and represents insofar a consensus, and to reach such a consensus among 12 countries is, in my view, a genuine achievement in itself.

Let me conclude by mentioning that the present monetary stance in the euro area is widely seen as appropriate, as also documented in the concluding statement of the last mission of the Fund. So all in all, we are quite happy with the situation as it is right now.

Let me stop here, Michael.

MR. BERTOLDI: Since Gerald has focused on the changeover in the short term, I would like first to give a little bit of medium-term perspective. Less than 13 years have passed since the approval of the DeLors Report on the building of an economic and monetary union in the European Community and the European Council of Madrid. In less than 13 years, we have moved from stage zero to the accomplishment of the third and final stage of the process, the physical introduction of the notes and the coins.

This is indeed a remarkable achievement if you think of the number of countries involved, the sheer size of their economies and populations, as well as the different institutional settings that existed in 1989. I can't agree more with IMF Managing Director Kohler when in his remarks on the occasion of the informal meeting of the December 14 meeting of EU Finance Ministers in Lachen, he said, I quote, "The euro project is a success. In a remarkably short time, it has created a large stability-oriented economic and monetary space."

It was not evident from the beginning that the euro project would be a success. Before May 1998, many considered the creation of a single currency in the European Union politically unrealistic, technically impossible, and economically dangerous. After May 1998, it was not politically unrealistic but remained technically impossible—and I have to say that still in December I received phone calls here asking whether it was true or not that the postponement of the introduction of euro notes and coins—and remained also economically dangerous.

After the 1st of January 2002, it has become technically possible, so we are left with only one issue of contention. Is the economic and monetary union economically dangerous? Well, I would hope that after today's symposium we could solve the issue and say that, no, it's not economically dangerous and everybody agrees on that.

Let's consider the benefits of the euro in a medium-term perspective, since it's too early to have a long-term perspective. At the beginning of the '90s, much of the European Union economy was characterized by a high inflation rate and high budget deficits. When the Maastricht Treaty was ratified in 1991, the euro area inflation rate in what is now the euro area was about 4 percent, and the average budget deficit was 5.5 percent. In the subsequent years of preparation for the economic and monetary union, the situation was transformed. A new culture of economic stability has been established in Europe based on a strong commitment to low inflation and budget discipline. The euro area inflation rate fell close to 1 percent in '98 and '99. As we know, it went up above 2 percent in 2000-2001, mainly because of a surge in oil import prices and the agricultural shocks that affected the European economy. But in 2002, it should return to below the 2 percent level.

The euro area budget deficit in 2000 was below 1 percent, and despite the current slowdown, we've stayed below 2 percent both in 2001 and in 2002.

This culture of economic stability has borne its fruit in 1999 and 2000. After some difficult years, in 1999 and 2000 the euro area enjoyed high growth and strong employment creation. More than five million new jobs were created during this period before the worldwide deceleration in output growth in 2001 slowed down this process.

Another key benefit of the euro has been the removal of the most important remaining barrier in the new single market: the coexistence of multiple national currencies. It is not true for all the 15 EU countries, but it would be for 12 of them. In this respect, the euro is definitely a superior public good compared to the public good represented by various national currencies. With the euro in place, member states have now started to reap the benefits also on the macroeconomic level:

First, the euro is bringing increased price transparency and more intense competition to the marketplace.

Second, by eliminating the burden of managing exchange rate risk within the euro area, the euro has lowered transaction costs for financial services of companies and individuals.

Third, there are now greater opportunities for financing and investing in the deeper and more liquid euro-denominated financial market.

Last, but not least, the euro has been a magnificent, to quote French Finance Minister Fabius, shield against intra-European currency instability. Few European currencies would have escaped the repercussions of the Asian currency and financial turmoil or more recently the repercussions of the burst of the IT bubble, or the aftershocks of the September 11 events in the absence of the process of economic and monetary unification. Wide fluctuations in intra-European exchange rates have been in the past important sources of economic and political tension inside the European Union, not to mention possible inflationary repercussions. With the euro, and already with the move to the euro, all these drawbacks have disappeared.

However, there are no doubts that the economic and monetary union now faces various challenges which are testing how well it does work. The first and most immediate challenge is the correct policy response of the euro area to the present difficult economic situation. The fast deceleration of output growth and, until recently, accelerating inflation, has proved a tough test for European policymakers. Our response has been to ease monetary policy, and several euro area countries have carried out tax cuts corresponding to about 0.5 percent of GDP of the euro area. And, furthermore, the economic slowdown has activated automatic stabilizers.

I would like to stress here that the countercyclical impact of automatic stabilizers on the European economy is often downplayed. I think that this is incorrect. The size of automatic stabilizers tends to increase with the size of the government sector, the progressivity of the tax system, and the generosity of an employment and benefit system. Therefore, the effect of automatic stabilizers is far from being negligible in the European context, and the European fiscal stimulus in 2001 and 2002 is significantly bigger than generally perceived.

Should, however, the euro area do more on the fiscal side? Past experience tells us that discretionary fiscal policy is not an efficient stabilization tool because of longer and more uncertain impact lags. Fiscal policy can easily become procyclical and, moreover, can be counterproductive if it were to jeopardize the soundness of public finances which has been regained, it's fair to remind here, during a decade of considerable political efforts. This could lead to a rise in long-term interest rates which would in turn lead the European Central Bank to reverse its policy of monetary easing.

Last, but not least, let us not forget that the euro area has less margin for maneuver because of this underfunded pension system which requires government budgets moving close to balance or surplus to face longer-term challenges.

First, on monetary policy, but I think that on the whole we have provided the right response on the macroeconomic level. So there are two areas in which I think that further improvement could be done. The first is structural reform because, despite the progress made in recent years, Europe still needs to do more. Most estimates of the potential growth rate of the euro area GDP are around 2. 2.5 percent. Even after a year of expansion, the unemployment rate remains unacceptably high, above 8 percent, and the slowdown in 2001, driven largely by external shocks, came as a strong warning signal that our economies do not have sufficient dynamism yet. Reforms in product, service, and labor markets remains more than ever at the top of the economic policy agenda.

The other area in which more improvement is needed is in the coordination of economic policy in the euro area, and in this respect, may I simply mention that the President of the Commission has recently suggested the development of a code of conduct which would take specific account of the interdependence of budgetary policies of the countries in the euro zone and would improve the overall coherence of the credibility of our policy.

To sum up, I think that we have a strong economic situation in the European Union, strong economic fundamentals, and this reality will ultimately convince the skeptics that the euro has been a success.

The last point that I would like to make is that, however, the euro is also important for its symbolism, and now that the euro is in the hands and pockets of all euro area citizens, there is no doubt that this represents an important catalyst for integration, which gives new momentum to the process of European integration.

Thank you.

MR. DEPPLER: Thank you.

Professor Henning?

MR. HENNING: Thank you very much, Michael. I'm pleased to be here participating on the panel this morning.

Analyses of EMU during the decade of the 1990s contained some bold predictions and warnings, and some of these in retrospect appear to be regrettable, and some appear to be prescient.

My candidate for the most regrettable is Martin Feldstein's suggestion that monetary union and attempts to consolidate political integration could lead to civil war in Europe, although war was not inevitable, he wrote in 1997, "it is too real a possibility to ignore when weighing the potential effects of EMU." One year ago, he reiterated that the monetary union is still more likely to increase conflict within Europe than cooperation.

By contrast, at the other end of the spectrum of our predictions, when addressing the French National Assembly, if I recall correctly, former French President Valery Giscard d'Estaing said that 20 years from now, the euro will be such an acceptable part of Europe that people will look back on the 20th century and wonder why countries insisted on each retaining their individual little currencies for such a long period of time.

Well, the first three years of the monetary union I think provide not a shred of evidence that political disintegration and war is now more likely in Western Europe. The introduction of the euro in cash form makes this an even more unlikely prospect. And I expect the next several years to demonstrate that Feldstein's concern is completely misguided.

Indeed, I think Giscard's forecast is far more likely to be the case. I also believe that the monetary union is very much in the interest of the United States and the rest of the world and will be seen to be so ultimately.

But there are, of course, still a number of things to do before arriving at a completely happy outcome. I'd like to divide my remarks into points about internal matters, matters internal to the monetary unions, and matters external to the monetary union involving the EU's external monetary relations.

Taking the internal matters first, prior to the monetary union, we saw predictions that monetary policy would for various reasons be too tight or too lax. Fortunately, while there probably is some room for further easing of monetary policy at the moment, monetary policy is not severely restrictive. And over the last three years it's been about right overall, despite at least one previous period during which the ECB, as now sometimes, was criticized as being too restrictive.

Earlier, we also heard some predictions that European fiscal policy would be highly expansionary, that the ECB would be forced to tighten in response, leading to the Reagan-Volcker policy mix with undesirable consequences for exchange rate and payment stability.

Fortunately, fiscal and monetary authorities in Europe seem to have understood the logic of the interdependence between their policies and pursued instead a policy mix closer to the Clinton-Greenspan model for most of the three years since the inception of the monetary union.

Mutual forbearance by national governments and the ECB is now being tested by the recession faced by at least one key country of the euro area, if not the euro area, though the recession is not forecast for the euro area as a whole.

Last year, prominent Ministers floated the possibility of revising the rules of the Stability and Growth Pact, but apparently fearing that the ECB would become even more reluctant to ease, national governments have given this up for now.

However, with Germany approaching the 3 percent limit and with important national elections in both France and Germany, the euro area might not be able to avoid revisiting these questions in the current year.

I believe that changes to the Stability and Growth Pact are desirable and should focus on cyclically adjusted deficits and thereby avoid having to make procyclical policy adjustments. But that does not necessarily and should not imply more laxity in the regime as a whole. But it is admittedly difficult to redefine the rules when a major country is bumping up against the limit without creating the widespread impression that the rules are being made generally more permissive.

Ideally, the redefinition of the regime should take place at the peak of the business cycle rather than the trough. If the euro area can skate through the current year without amending the Stability and Growth Pact, therefore, it should consider changes when the fiscal positions of its members are in good shape rather than waiting for the next recession.

Now, much has been made of the independence of the European Central Bank and the euro system. Some analysts argued in the last decade that independence was excessive and undemocratic, and I put Richard Cooper in this category. Others have argued—are worried that ECB independence is insufficient. And the institutional position of the ECB is also closely connected, of course, to issues of transparency and accountability, the roles of the national central banks relative to the center, the downsizing of staff in the system as a whole, and it's affected, of course, by EU enlargement and the broader reforms of the EU institutions that might redress the democratic deficit in the European Union.

I think it's important to stress that independence should not be confused with being apolitical. Central banks that remain independent over long periods of time are, in fact, highly political. They're not partisan, but they're highly political, and they actively cultivate a constituency for their autonomy. And recognition of the importance of maintaining such societal support is too often missing in discussions of the ECB as an institution. But the ECB's own political strategy is not entirely clear, not to me. It is safe to say, I think, that the ECB should not, would not be wise to rely exclusively and passively on its protected status in EU law, in the treaties and the statute. The ECB will have to cultivate this constituency as adroitly as the Federal Reserve and the Bundesbank have done.

Its institutional and political environment, of course, is considerably more complex and fluid, but the introduction of euro notes and coins will give the ECB a direct relationship to European citizens as the guarantor of the value of money in their pockets, and this may be one of the most significant consequences of the introduction of euro cash.

Prior to the introduction of the monetary union, we heard a great deal about whether the euro area met the tests of the theory of optimum currency areas. Most of the normative debate over EMU hinged on these tests. Opponents argued that fiscal policy was too decentralized, real wages too rigid, and labor too immobile for the euro 12 to constitute an optimal area. And under these conditions, they argued, the monetary policy appropriate for one country, say Germany, might well be inappropriate for another, say Ireland.

Despite some significant external shocks, though, such as changes in oil prices and the U.S. recession, growth performance appears to be converging within the euro area. And while conceding some of the optimum currency area arguments, proponents of EMU argued during the 1990s that monetary union would actually set in motion a set of policy reforms that would render the euro area optimal after the fact. And this has come to be called the endogenous currency area hypothesis after an article by Jeffrey Frankel and Andrew Rose. The IMF's own Pier Carlo Padoan with us this morning has done some work in this area as well.

I think that the most interesting question facing analysts of European economics is whether this hypothesis is valid. It is also the question on which the ultimate judgment of U.S. authorities might well hinge. Clinton administration officials argued that further flexibility in European economies was needed in order to ensure that monetary union was good for Europe and good for the rest of the world.

Of course, monetary union has spawned integration in European capita markets. More needs to be done. It's contributed to cross-border competition and to deregulation. More needs to be done there, too. And the stickiest and most important area is the labor market, and here, of course, the evidence is decidedly mixed—not negative but mixed.

I think two observations are in order.

First of all, this process of changing the political economy of policy reform in Europe is a very long-term process, and it would be premature to conclude that endogeneity is not sufficient.

And, second, the process of reform is not simply an economic one, but it's a fundamentally political one as well. And we need a decade for a definitive answer.

I want to make a few quick remarks on the external side. This is a category in which there are a lot of intriguing questions. One of the most intriguing for me is the broad question as to whether international monetary cooperation will improve or decline with the consolidation of the monetary union. And on this basic point, analysts have argued as well. Their views have been all over the map. One dominant forecast of the mid-1990s among economists was that mutual benign neglect would prevail. And this is a prediction which I do think has some support from the experience of the first three years, but this is inconclusive.

The report "One Market, One Money" argued that having a single dominant monetary power, the U.S., which the U.S. represented during previous decades, was not, in fact, necessary for international monetary stability, but creating a larger, more powerful partner in the euro area would actually improve bargaining outcomes over macroeconomic policy between the United States, Europe, and Japan. And this is done in the model that they used by constraining the United States to good policy choices.

The U.S. official posture has been complacent. When asked whether he feared the creation of the euro, Larry Summers as Treasury Secretary said, "The fate of the dollar is in our own hands." This, of course, is basically true. But it's also true that the United States has made some serious policy mistakes over the past decades, monetary policy in the 1970s and fiscal policy in the 1980s, and it could well commit such errors in the future. But any such errors will confront a greatly changed international environment. There would now be a serious alternative currency to the U.S. dollar, backed by a large internal market for goods and capital.

As the U.S. current account deficit has reached record levels and will likely grow with the U.S. recovery, which we forecast over the course of the coming year, the ability to finance these deficits may be called into question. And in this environment, it's worth reflecting on the year 1987. Owing partly to the depreciation of the dollar during the previous two years, since 1985, private capital flows into the United States largely dried up in that year. And instead European central banks and the Bank of Japan financed the large current account deficit at that time through foreign exchange intervention.

America's partners were willing to do so in order to distend the appreciation of their own currencies and, thus, the reduction in their trade surpluses and, by extension, in their growth in employment. If private capital flows were to dry up in the next few years as they did in 1987, the euro area would be less vulnerable to exchange rate fluctuations than the individual European countries had been prior to the monetary union's creation. European authorities might not be forced into the breach. If they chose to finance U.S. deficits, European officials might this time insist on U.S. policy adjustments as a quid pro quo.

The instances where the monetary union could impinge on the choices of the U.S. policymakers will almost certainly be rare. But they're more likely to occur when the United States is running large current account deficits.

Now, there's no guarantee that the adjustment will be smooth. In fact, one could easily lay out a fairly ominous scenario for the dollar and current account adjustment over the next several years. Under the circumstances, it will be important to have a well-functioning mechanism for international consultation and a demonstrated capacity for more deliberate and sustained joint action in the markets than has been manifest by U.S.-European cooperation so far over the three years of the life of the monetary union.

Finally, I think it's useful to say that in this environment it's also important that both sets of officials in the U.S. and in Europe forswear competition over the international roles of their currencies. Some Europeans will be tempted to promote the euro through diplomacy and official measures. But the right way, in my mind, to promote the euro is by integrating, broadening, and deepening the European financial market, making the euro more attractive in this way. This kind of competition I think would be welcomed on this side of the Atlantic.

Thank you very much.

MR. DEPPLER: Thank you.

Mr. Baker?

MR. BAKER: Thank you very much. I hesitate before reinforcing everybody's national stereotypes, but here I am as the British representative on the panel and, sure enough, I'm going to express some good old-fashioned British skepticism about this project.

Listening to the euphoria, I think it's fair to say, with which the introduction of the euro notes and coins in the last two weeks has been greeted, certainly in Europe and to some extent even around the world, I am reminded of the very similar euphoric expectations that greeted the introduction of the euro itself three years ago, which has been discussed a little bit already here.

I do recall very strongly at the time European leaders saying that this was going to be a strong currency; this was going to be a currency that would replace the dollar as the world's reserve currency within a short space of time; it would be reflective of a strong, vibrant, effective European economy that would itself overtake the U.S. economy within a relatively short period of time; and people would be—investors around the world would be flocking to Europe to take part in this great economic triumph.

Well, that lasted about a week. As you recall, the euro started at an exchange rate of about 1.16, 1.17 to the dollar, and proceeded to fall like a stone throughout the next year. And despite repeated bouts of enthusiasm for the European project, it's still some 25 percent below the rate at which it started. In fact, for those of you who follow baseball, that put me in mind of a rare thing, a rather good economics joke, which goes like this:

Why is the euro like the Chicago Cubs? Because they both peak on opening day.

What I want to particularly address is, as I say, the euphoria, the excitement with which not just the Europeans have greeted the euro, but with which many people around the world and some governments around the world—not, I have to say, the Italian Government, which doesn't seem to be entirely—it seems to be about as excited about the euro as the British people.


MR. BAKER: But I want to address the sense that is around that the euro is going to be not only a great economic success, not only is it going to create, as we heard three years ago, this great, vibrant economic system, but it's a political success, too; and that actually it will hasten—it will improve intra-European cooperation, that it will eliminate the risk of tensions between Europeans, and that it should be regarded by the rest of the world as a uniformly unmixed good thing. I don't think it is, and I think there are three reasons at least why I think we should keep our euphoria in check.

First of all, as Professor Henning did address, there remains the question of whether or not this European monetary union can function in what is clearly not by any measure an optimal currency area. There is the notion of a one-size-fits-all monetary policy for a European economy that is extremely divergent, more divergent, actually, than the U.S. economy, without the kind of protections, again, that Professor Henning mentioned, without the availability of strong fiscal transfers, without the kind of labor mobility that exists within the United States, without the flexibility more broadly in labor markets, flexibility of wages in particular.

That has not been tested, and I take issue with this proposition that the last three years have somehow proved that all these doubts were complete nonsense. We are three years into this project, three years of moderate growth, not impressive growth, certainly not as impressive as the growth that the United States has had. It's been relatively weak growth, but there hasn't been an economic crisis in Europe. There hasn't been a recession in Europe in the last three years. The German economy is clearly in something close to recession now. But there hasn't been the kind of normal—[tape ends].

—serious downturn that we would expect. And I would say that you cannot possibly judge the success of this process until you have seen at the very least one full business cycle and seen how the divergent European economies function and how a single monetary policy functions for those economies as the European economy, as it will at some point, goes into a fairly serious downturn. It's simply too early to say that this is the last—that just three years of a single currency have somehow proved this to be a tremendous economic triumph.

I would also point out that the fact is that most of the crises, the financial and economic crises that have happened in the last ten years around the world have had as a large part of their roots the importation by countries of a monetary regime through a fixed and hard currency which is entirely inappropriate for their own domestic economies. It was the case in the ERM, the exchange rate mechanism crises of 1992 and 1993. It was the case in many of the Asian economies in the financial crises of 1997-98, and as we're tragically seeing in Argentina today. A monetary policy through a fixed exchange rate permanently—I won't go into the—obviously we can argue about the differences between currency boards and adopting a single currency, but there's no question the point is the same: To import a monetary regime in an effort to achieve economic integration and the same kind of inflation performance as the strong currency at times is simply not appropriate. And we cannot begin to say the euro has been a success until we've seen the kind of—until we've seen an economic downturn which puts pressures on the weaker European economies, and even on some of the stronger European economies, and we'll see then whether or not the single monetary policy that the ECB is operating, whether or not that is effective and popular.

The second reason we should hold our euphoria in check is that, again, the promises that were made three years ago, if you recall, were that the introduction of a single currency would lead to an economic transformation in European microeconomics, that we would actually see a radical change, the kind of change that the United States and other outside economists, particularly in Britain as well, have been urging on the European economy for a long time, that we would get these flexible labor markets, that we would get significant reforms to the kind of fiscal—to the fiscal position that operates in many countries. We were told, we were assured repeatedly back in the late 1990s that this was going to happen, this was inevitable, it would be an inevitable product of monetary union.

Well, again, I refer to my own argument, of course. It's early days, perhaps, but we've seen very little sign of really radical structural change. In fact, those governments that were committed supposedly to making some really important radical changes—Germany and France in particular—have backed away and we've seen—and no one should be particularly surprised by that. There isn't the kind of—the European political debate is such that there's no great desire to emulate the U.S. economy. There's no great desire among Europeans or among European governments to create the kind of dynamic, free-market economic system with all the disadvantages, I should stress, of course, that that has of inequality and potential instability. There's no desire on the part of Europeans to do that.

The problem is that if they don't do that and if they don't make the kind of important structural reforms that most economists I think still would agree are necessary, it's pretty clear that the U.S. economy is growing, is at a long-term trend rate of growth which is considerably in excess of the euro zone's trend rate in growth. I think most economists with put U.S. trend growth in the range of about 3.5 percent. Euro zone trend growth is maybe 2.5 percent. This is going to lead, if something doesn't change, to growing international economic difficulty. We've already seen it, and as Professor Henning, again, mentioned with the current account deficit, the U.S. current account deficit, if trend U.S. growth as well as the trend—U.S. propensity to import is much higher than it is in Europe, we are going to—we have a problem there where the two largest economic blocs on the world are going to be in a fundamentally unsustainable situation.

So unless Europe, in my view, makes the kind of changes that are necessary and elevates its long-term trend rate of growth, deals with the problems of considerable safety net protections of very, very limited labor market flexibility, we are quite possibly headed for continuing international economic instability.

The third reason and the most important reason, really, why we should regard this project with a certain amount of skepticism is that it is not now nor was it ever a popular program rooted in broad political legitimacy on the parts of the people of Europe. Very few people in Europe wanted this project. I think I'm still right in saying that the referendums in Europe that have been held, when people have actually been consulted, more countries have actually rejected joining the euro than have actually been in favor of it. And the one country, the one large country that held a significant referendum, France, in 1992, the vote in favor of monetary union passed by 50.1 percent for 49.9 percent. It is not, emphatically not a popular project.

Now, of course, it's fair to say that people have greeted it reasonably with, I would say, resignation rather than particular enthusiasm in Europe. Mr. Grisse talks about Germans queuing up to get their euro packs. Well, I think, as I recall, the packs of euros were introduced at somewhat of a discount to their real exchange rate value, and the Germans being of sound economic mind know a bargain when they see one.


MR. BAKER: And doubtless turned up and made a handy turn for their money.

This project does not—I mean, this is a serious and worrying point. It's not even a question now of whether or not people accept the euro, because, of course, I think they do. Of course, in the major European countries they do accept the euro as a fact of life. The much bigger problem is the euro will require a much greater degree of economic policy coordination and integration, and that will require over time more fiscal policy coordination. We've already seen some of the stresses of that in the last year or two. There's going to be—more of that is going to be necessary. That means more and more there is going—countries are going to be forced to do things that have no popular political legitimacy in those countries. If we have a harmonized tax regime, for example, that's highly controversial, but many people believe that for the euro to work effectively, we will have to have at some point some kind of harmonized tax system in Europe. For a currency union to function effectively, it has to have popular political legitimacy. It hasn't been tested yet. It will be tested at some point. I hope that it manages to succeed, but I fear quite strongly that, without the popular support and without the degree of prior economic and political integration, we could be headed for some bumpy times ahead.

MR. DEPPLER: Thank you.

Well, ready, not, glass quite full, glass rather empty—you have an array of opinions. The floor is to you. Please use the microphones when you want the floor and identify yourselves.

MR. : Good morning. My name is Tagi Sada-(?) . I'm a professor at Loyola College in Baltimore. Thank you very much for all the panelists' contributions. I have three questions.

One was touched upon briefly by Professor Henning and had to do with the impact of the euro as a reserve currency in relation to the dollar in the medium- and long-term basis.

The second one is the extent to which the euro is likely to be adopted by non-EU countries in a manner similar to the dollarization concept.

And the third one is something that was not mentioned, and that is the other multinational currency, namely, the SDR. And so I would like to ask the third question in connection with the relationship between the euro, the dollar, and SDR.

Thank you.

MR. HENNING: Well, I'll take a crack at part of that set of questions.

Our conventional wisdom suggests that the euro is kind of more likely to be adopted by non-EU countries in the geographic vicinity of Europe nationally, that we will see use in Central and Eastern Europe, and kind of beyond those countries that are now being considered in the next wage of enlargement.

The role of the euro as an international reserve currency, of course, is a very interesting question. It's attracted some recent headlines, with the Chinese suggesting that they want to diversify their reserve holdings further and to weight the euro more heavily. And we've seen—this is exactly—for the U.S. and European authorities to actually compete in China over the allocation of China's reserve portfolio is exactly the kind of official competition over the international role of the currency that I think could be unconstructive. It's fine if China arrives at these decisions on its own, but it would be destabilizing for the U.S. and the Europeans to compete in this respect.

The reserve role of—empirically speaking, the reserve role of the euro has actually declined over the last couple of years by an—relative to the European—the individual European currencies prior to the monetary union for almost an arithmetic reason, because the—related to the cross-holdings among the European central banks of their own currencies.

Over the longer term, with the integration of European capital markets, with the fall in the cost of—the transactions costs of investing in the European market, I would expect the international role of the euro to increase over time. It will displace partially the role of the U.S. dollar, but it won't replace the U.S. dollar as an international currency, and U.S. authorities are going to have to get used to—are going to have to accommodate a role for the euro, which someday may be approaching that of the dollar in the international reserves.

MR. GRISSE: Yes, I more or less fully share Randall's views. Let me say that the most important point I see when we talk about importance of the euro, possible future importance of the euro as a reserve currency, is for me that we take out this competition argument, and that was also absolutely correct, emphasized by Randall.

What is going on here is simply kind of long-term political change, and in the longer run, this political change should lead to certain—let's say a certain rebalancing also in the composition of international reserves. That will most likely happen, but we do not know when it will happen.

I remember very well that the two of us were at the panel in Ireland, in '97 or in '98, and at this time the expectation clearly was that the euro would from the beginning take on this role as a second reserve currency and that this role would improve as compared to the role of the contributing currencies.

I am still of the view that this will happen in the longer run. China is only one prominent example for other countries that may follow. But this is, on the other hand, nothing that we should see as, let's say, a kind of question of success or non-success of the euro. It's something that follows, and for us we see it in a relaxed way. It should happen at some stage, but we can do without so far. So let's see what happens.

MR. DEPPLER: Just to answer the question on the SDR, I think—Jacques Polak is sitting in front of me, but I think the analogy in between the SDRs with the ECU and the euro when it became sort of a wholesale currency, sort of started going beyond the SDR, and then now that it's in people's pockets, I think it's in a different league from the SDR. I'm not sure, Jacques.

Arnold, you have the floor.

MR. Wijnholds: Thank you very much, Michael. I'm Beaufort Wijnholds, the Dutch Executive Director in the IMF. I particularly wanted to briefly focus on what Mr. Baker said. I think his contribution was the most stimulating one in the sense that he was the most stimulating one and, therefore, the most valuable probably in this setting, because we do need to have a critical look at this whole project. You can imagine, my former boss is Bill Duisenberg so I have to be very upbeat about this.

But at the same time, I believe we do have to maintain a critical distance, and in that sense, I'm pretty confident that Michael Deppler and his staff will keep looking very closely at what is happening.

But I did want to perhaps challenge a little bit here and there your British skepticism, if I may. For instance, I think you very—well, I would almost say glibly, make the point that the euro zone was not an optimum currency area. But you did not give any arguments for that. In fact, if you talk to Bob Mundell, who developed this theory, he would say it is. So, you know, there is a difference of opinion there, and you may use a different definition.

You make, I think a very valuable point about the need for further structural reform, and here I think, for instance, the ECB would definitely agree with you. And I think this is also a point that is repeatedly made in IMF documents, and rightly so.

I might just say that I think there has been some improvement. A lot needs to be done, but, yes, definitely structural reform is where the larger increase in productivity that we need in Europe will come from, leading also to larger creation of jobs, and particularly labor market flexibility is important.

Now, there are a few exceptions in Europe. I think Ireland was already mentioned. I might mention my own country, the Netherlands, where there has been more structural reform, also particularly in the area of the labor market, not yet sufficient, in my view, but leading to job creation to the tune that is comparable to that of the United States. So I think there are pockets there that may show the way forward.

Finally, on popular support for this project, you are right that if you look at what people said in the past, they were quite reluctant. Often populations are. But once the project gets going, it often—the mood can change. And I think what is interesting is to see that in Germany, for instance, where there was quite a bit of skepticism for exchanging the deutsche mark for the euro, the eagerness to get the euros has been quite tremendous. I don't want to overdo this argument, but it is something. And I also take note that Sweden is now also, in fact, contemplating a referendum.

So these are a few remarks from my side. Thank you.

MR. BAKER: First of all, I'll take them in reverse order, if I may.

On the question of popular legitimacy, yes, as I say, the euro is accepted. I think that's clear. But, I mean, if you tell people that they are no longer going to be able to use their deutsche marks, francs, and lira after the middle of February or the end of February, no one should be surprised that people want to go out and get euro. I'm not suggesting that there is a kind of popular guerrilla movement out there of people, you know, using their old currencies in an attempt to undermine the new currency. Of course, there is an acceptance of it. My broader point was that I think that the kind of further economic and political integration that will be required by the euro—and I just think it will—is going to be very, very, very—is going to create real stresses and strains, the kind—and going to force changes on governments that will not have popular legitimacy.

On your second point about structural reform, I certainly agree with you about the Netherlands, I mean clearly, but the Netherlands is not, as it were, the problem here. The Netherlands has a very flexible, in many respects, very, very flexible administration, more flexible than the so-called Anglo-Saxon economies. The bigger problem is still with the bigger countries that make up the bulk of the euro zone.

And on the point about optimal currency areas, yes, I know Mundell's, of course, seminal work on it. Clearly there was—there is a kind of de facto economically integrated single currency area at the heart of the EU. I wouldn't dispute that. Germany, Austria—Denmark, interestingly, though, of course, choosing not to be actually in the euro—plus Netherlands, Belgium, and Luxembourg, certainly, and arguably France—I mean, France has always been there, but that's been a de facto currency union for the last 20 years with the slight hiatus of the crisis in the early 1990s.

Where I think it gets much more contentious and where the problems are much more likely to arise is with the periphery. I think that Greece, Portugal, probably Spain, to some extent Ireland, and certainly if you start adding in Poland and the Czech Republic and Hungary, you are going—you are creating a very, very significant disparity in economic conditions and performance. You already have it and you will exacerbate that if these countries under enlargement come into the euro at some point. And that is going to—that's not going to go away for a long time.

The United States is an imperfect optimal currency area. I'm absolutely the first to acknowledge that. But, of course, it has, as we've discussed, the kind of structures and conditions that enable some of those problems to be resolved.

So, yes, there is at the core of Europe probably an optimal currency zone, or something close to it. It is the kind of—it's the conditions in the periphery that I think are much more a source of concern.

MR. [Unidentified]: I had one direct question to Mr. Baker because I see a slight inconsistency in your argument. You talked of the euro as imposing a strong currency, let's say, on countries that used to have a weaker currency. But, on the other hand, the talk of the day is why is the euro so weak, and is this the right development for the European economy? So you cannot have it both ways. I mean, either the euro is—you see the euro as, let's say, a strong currency which is imposed, or you have the feeling it's weakening, and the weakening is a fact that you wouldn't accept.

Could you comment on this point?

MR. BAKER: Yes, it's the monetary policy that is being imposed on countries that have not—are not necessarily in the position to accept the kind of monetary policy. It's true the euro has weakened against the dollar since it started, and, in fact, since 1999. But for many of the countries that have joined it, it still represents—indeed, the reason they joined it was that it represents a harder currency in international markets than the one that they gave up, one that seems to have a more stable—certainly seems to be more stable. And as I say, it's the question of whether or not the monetary policy that is obviously—the single monetary policy that obviously accompanies a single currency, whether that is appropriate for the divergent economies in the euro zone, and I don't think that's clear yet. And as I say, until we go through at least one business cycle, I don't think it will be clear.

MR. DEPPLER: If I might make one comment here, the viability of the euro area is very much a function of the nature of the shocks that hit the system, whether the shocks are symmetric and demand oriented, or whether they're asymmetric and supply oriented. It's conspicuous that there's been quite a change in between the early '90s and the late '90s in the nature of the shocks that have hit the system.

In the early '90s, we had a period of fairly asymmetric shocks, and the ERM crisis was bred, in fact, from the presence of asymmetric shocks. The past three years have, in fact, been a period where shocks have been quite symmetric and synchronized. So Mr. Baker is correct in saying that the system really hasn't been tested so far.

The next question from the floor. Yes?

MR. PADOAN: Thank you, Michael. Pier Carlo Padoan, Executive Director for Italy at the IMF Board.

I'd like to thank Mr. Baker for giving us the usual long list of your skepticism, with the addition of the newcomer Italian being a euro skeptic. May I suggest that you read the interview in your newspaper the Italian Minister just gave—if I'm not wrong, today—about that. But the fact that—that is not the point I'd like to discuss with you today. There are three points which you raised I think are worth considering.

First of all, one point you raised about the international position of the euro area vis-a-vis the U.S., and you mentioned one point I really did not understand. The fact that, true, Europe and the U.S. have a different potential output rate of growth would be a source of instability. That sounds very odd to me because that would mean that you would have instability all around the world because we do have different rates of growth of potential output everywhere. What we do see is convergence rather than instability.

So if that is the case, I would not unwelcome the fact that Europe has a lower potential output growth with respect to the U.S. because that is a source of possible catching up of Europe towards a higher potential output growth.

The second point, which is the same one, although related to within the European area, not just the euro zone, is to say the periphery. As Mike Deppler just mentioned, if you look at the evolution of variables, both macro and micro structural variables, across the countries that today make up the euro zone, you do see a lot of evidence supporting what Randy Henning mentioned, referred to as the endogenous currency area approach to EMU, which suggests not necessarily as a mechanical outcome but as a possible outcome that, because of monetary integration in different forms, including the EMS, there is convergence of not just macroeconomic variables but also in some cases in structural variables.

We all agree that what Europe needs to do is to increase the speed of structural reforms which would deliver a higher potential output, therefore increase the convergence vis-a-vis say the U.S. potential output, which we all do hope is that high, by the way.

The third point, let me just mention the fact that it is maybe a paradox that today, as we see the successful introduction of notes and coins, what we do see in Europe is not so much an economic outcome. Indeed, some mentioned the fact that the euro exchange rate jumped up a bit and then went back to what appears to be its medium-term value today. And there is little evidence, as Mr. Grisse mentioned, of inflation because of the rounding up.

So my point is that it is a paradox that the practical introduction of euro is not really an economic short-term impact but, rather, a major political longer-term impact. Maybe it should be mentioned here that alongside with the introduction of the euro, what the European Union is witnessing in the year ahead is a broad discussion about its constitution, which will fill, hopefully, at least in part, the gap, which Mr. Baker actually mentioned, between citizens and institutions. And if we believe that the introduction of the euro is not just an economic event but basically a great political event, that would help close that gap, which certainly needs to be done, so including the fact that this will make the European Union ready for the other big event, which is enlargement to up to 30 countries, in which, of course, the euro helps catalyze.

Thank you.

MR. BAKER: Well, again, on the last point first, yes, you know, I'm glad you acknowledge there is a gap between popular attitudes toward European integration and the stated policies of the political elites in continental Europe towards accelerating, speeding up the pace of European political integration. You may well be right that the way to do it is that the customary European approach is for the elites to go first, as it were, and pull the populations along in some way. You may well be right. I mean, it may well be that that is the way that it will go and that there will be acceptance of and, indeed, Europeans will come to welcome the euro and what it represents and all the policies that are associated with it, much the same way that they came to accept the European coal and steel community and the European economic community and the European Union because they weren't particularly enthusiastic at the start about most of those things either.

However, I would argue that European monetary union represents something really significantly different from the pattern of European integration that we've seen over the last 40 years. It is a much more significant leap for Europeans to take, and it does both produce and require a much greater degree of de facto, real political integration than anything that's been done before—you know, the introduction of the single market or the original—as I say, the various communities, the introduction of the original communities.

So I think it's a much more significant leap, and I think the challenge is going to be that much harder to persuade European governments—European peoples to come along.

On your first point about the differential, of course, different countries have different—there's differentials in growth rates. What I said was that the combination of a significant gap between trend growth in Europe and the sharply higher U.S. propensity to import that we've seen over a long period of time and has been behind the increase in the U.S. current account deficit. And I think that economic convergence globally is something that, yes, absolutely we should aim for, and that until we get that, the chances are that we will not—that the U.S. current account deficit will continue to persist. It's persisting even in the face of this recession that the United States is going through. And as I say, longer term, unless there is much greater convergence globally, then that is going to be a source of instability for the global economy.

Sorry. Your second point was about structural reforms?

MR. PADOAN: My second point was that you do observe some structural change within the euro area, and the convergence argument can be made for a larger union as well, not just between the U.S. and the euro zone.

MR. BAKER: Sure. There's been some; I wouldn't dispute there's been some. I really don't think, however, if you look at the political agendas of the major European governments, say in France and Germany, in particular, I don't think you—it's possible to be very optimistic about really substantial reform. And I point to Germany in particular. One looming problem-which the German government is clearly not able or willing to address—is unfunded pension liabilities. That is going to grow to be an enormous problem in Germany, which is going to threaten the entire euro zone as a result of the locking of the German economy into the European—into the (?) European economy through the currency union.

That is something that hasn't been addressed. It's getting closer, we're getting closer to the point where that will be much more of a pressure, a fiscal pressure on the rest of the euro zone. And I don't see any sign, any political willingness to deal with that problem at the moment.

MR. MORRISSEY: I'm David Morrissy, the National-Louis University. My question is four simple parts.

Number one, have the countries burned their bridges and are unable to turn back?

The second part is you look for growth of the euro with countries like Czech Republic, Poland, Turkey perhaps. Would that also in the long run be Russia?

And the third part is if the euro does become so, you know, acceptable and so forth, can it possibly not be in competition with the dollar?

And the final part is how long will the U.K. continue in the spirit of that legendary headline, "North Sea Storm Isolates the Continent"? Will the U.K. join?

Thank you.

MR. HENNING: Well, just a quick response to some of these points. Is it possible for countries to exit the monetary union? Well, of course, provision for that hasn't been made legally. Technically, sure, it's possible to exit a monetary union. It just now becomes very expensive to do so in a lot of various ways. And the introduction of European notes and coins makes that even more difficult to do. So I think—there have been a number of people that have suggested that the monetary union, you know, could, in fact, fall apart under the strain of the tension within the one-size-fits-all monetary policy. I think this is unlikely.

The question of Russia is a very interesting one because if we should see the Russian economy shift from dollarization, partial dollarization, toward euro-ization, that would be a very interesting signal that the euro is making substantial inroads on the international role of the dollar. The competition between the two currencies in the markets, yes, indeed, is inevitable. In fact, U.S. policymakers, including Alan Greenspan, the other officials as well, see a market-based competition between the euro and the dollar as actually being a very desirable thing, working to the benefit of both investors and issuers of international financial assets.

It would not be constructive for the authorities to compete over the promotion of their currencies in these international roles.

MR. GRISSE: Well, only a short follow-up. On the enlargement part of your question, the most interesting thing about the euro for me is that the Europeans by introducing this currency have put themselves under pressure to move to reform, if they want it or not. In such a big economic area, you cannot switch on structural reforms as you switch on the light, but what is more important is that you switch on a kind of mechanism, that you enter a kind of mechanism that puts yourself under pressure to bring about reforms. That's what they have done.

In this context, they are also committed and we are committed to enlargement. That does not mean that we neglect the problems coming along with this. And it's one of the very interesting things about European integration, that it's very difficult to define where—how this process will go, where it will stop at some point, and, let's say, how smoothly it will go. All we know is that we have agreed on certain rules, that we are sticking to these rules, and that means this community and also the monetary union is open to accession countries if they also fulfill the criteria and fulfill the rules. And this is basically the only thing you can do, the only choice you have, agree on rules for a process. Nobody knows right now where this process will lead us within the next 10 or 15 years. So it is a daring and a bold project, but it is a project without any alternative for Europe, I would say.

[Inaudible comment off microphone.]

MR. BAKER: I'm pretty sure the British Government won't hold a referendum until it believes it's almost certain to win it, and on current opinion polls, the majority is a solid 60 to 70 percent against euro membership.

Now, I'm perfectly willing to acknowledge that. Of course, that could change. And if the euro works successfully, against my suspicions and fears, if actually, you know, important reforms are made, the euro zone grow quite well over the next few years, that there don't seem to be the kind of stresses and strains that I talked about, of course, it's plausible that the British people will bury their doubts and vote to join the currency. At the moment, for political reasons, because of the electoral timetable, Tony Blair would clearly like to hold a referendum, if he could, within the next year to two. Gordon Brown, the Chancellor of the Exchequer, clearly seems against the notion of European membership—British membership, and I don't see how you could have a government where its two principal figures were divided in having a referendum campaign.

So, to be honest, it seems unlikely in the current parliament, which is due to end in 2005, and then I think we'll be, you know, considering it again sometime between 2005 and 2009.

MR. DEPPLER: Okay. I think we'll close it off there. I want to thank you all for coming.

I do think the—personally I don't see a question of the survivability of the euro. I do see a question about how efficient the euro area will be in using its resources over the longer term, and that's a question that remains out there, and I think all the speakers have emphasized that this is really the main issue on which the focus needs to be. That's certainly our view.


MR. STARRELS: This basket contains four cards so far, do I hear eight? Please drop your cards off and thanks a lot for coming.


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