SAN FRANCISCO: Hidden behind the euro's falling exchange rate is a life-and-death struggle between it and Europe's welfare state. Either the euro subverts the welfare state, or Europe's welfare state will subvert the euro. Despite today's weakness, smart money should bet on the euro.
The euro's disappointing performance - falling from a value of a $1.18 at its inception to a recent low below $.90 - is in large part due to Europe's reluctance to adopt structural reforms to increase economic flexibility. ECB Chief Economist Otmar Issing writes: "Germany and other European Union countries share the blame for the euro's weakness because they failed to make their economies more flexible."
But there is a world of difference between the euro's need to tame the welfare state and its ability to do so. Harvard economist Martin Feldstein, indeed, believes that "the single currency will be a political impediment to reform." "Politicians", writes Feldstein, "can now blame the ECB for high unemployment and complain that it is a powerful force beyond national control."
Another, more likely, outcome exists: if anti-competitive policies pursued by a country sink the euro, they will be condemned as "anti-European." For Europe's political leadership, the euro is a sine qua non -- an experiment that cannot, and will not, be allowed to fail. If short-sighted national economic policies threaten the euro, they will spark powerful countervailing political pressures on offending parties to cease and desist.
The recent Vodafone-Mannesmann merger is an example here. When Britain's Vodafone signaled its intention to takeover Germany's Mannesmann, Chancellor Gerhard Schroeder protested against the merger on grounds that it would cost German jobs. The euro fell in value with this news. ECB Chief Wim Duisenberg responded brilliantly, pinning an Aanti-European@ tail on the German donkey by proclaiming that the euro was threatened by Schroeder's anti-competitive actions. Unwilling to be labeled anti-European, Schroeder backed down.
Besides equating welfare state policies with anti-Europeanism, the euro will spark reform by forcing EU member governments to compete to attract mobile capital. The euro increases capital mobility inside Europe by eliminating exchange-rate risk on intra-European transactions. No longer trapped in a single country by fears of adverse currency movements, firms can relocate anywhere within the euro-zone. That means they can bargain with member governments to get the best deal possible on taxes, government regulations, and labor rules.
To encourage companies to locate in the Netherlands, for example, the Dutch are willing to bargain on taxes. Belgium and Denmark have passed business-friendly laws and regulations. This "race to the bottom" in anti-competitive measures will spark a corresponding "race to the top" in European growth rates. The result can only strengthen the euro.
Europe's left saw this coming and is trying to squelch government competition by using the European Commission to "harmonize" European taxes, regulations, and labor standards at high, anti-competitive levels. Former German Finance Minister Oskar Lafontaine tried and failed to use this tax harmonization ploy to trap German capital in high-tax Germany. Brussels is said to be taking aim at the Netherlands to harmonize away its competitive concessions.
In addition to EU harmonization, some European politicians propose restrictions on internal EU market activity to fend off the "race to the bottom." At the recent Lisbon EU summit, Nicole Fontaine, President of the European Parliament, asserted that "ruthless exploitation of the disparities between social and fiscal legislation in member countries" justified restrictions on corporate takeovers. Such talk only adds to the euro's woes.
Not all European leaders attribute the euro's weakness to structural factors. Some think the US dollar's strength against the euro reflects the fact that America and Europe are at different stages in the business cycle. Once the US slows down and Europe picks up, the euro will do better. But Europe's economy has been stronger than Japan's, yet the euro has fallen dramatically against the yen as well as the dollar.
Other knowledgeable European voices point to the fact that the DM hit all-time highs against the US dollar when Germany's structural problems were even more severe than at present. But the DM is not the euro.
In the past, German Bundesbank enjoyed a credibility gap vis-ŕ-vis the Federal Reserve. Today, the ECB suffers a credibility gap vis-ŕ-vis the Fed. In the past, foreign exchange markets paid less attention to structural factors. Today, an economy's ability to compete in a globalized economy is paramount to how foreign exchange markets value a currency. This is particularly true for the euro as the currency of the "New Europe." If the "New Europe" fails, so will the euro.
Once Europe's political leaders recognize their failure to make necessary reforms is threatening not only the euro's foreign exchange value but also its existence, reforms will be made and the euro will soar.