Europe on the Brink of Monetary Union

CAMBRIDGE: For several years Europe has held its breath wondering whether European Monetary Union would actually happen. After traversing a minefield of obstacles, EMU is on the threshold of realization. The question is no longer whether EMU will happen, but what it will mean for Europe. I predict that EMU will be launched with an initial success that will confound its worst critics, but that the success will be followed by years of difficult challenges that will confound EMU’s most optimistic supporters. In short, EMU will happen; it will survive; and it will disappoint those with ardent hopes that monetary union will create a new European economic miracle.

Upon the launch of fixed rates -- which will formally occur in early 1999, but in fact will begin in mid-1998 -- EMU will lead to efficiency gains in financial markets. The social costs of managing exchange rate fluctuations and uncertainty within Europe will fall (but not be entirely eliminated for a few years, since backsliding will still be a possibility). The chances for increased scale and competitiveness of key financial sectors, such as insurance, pension funds, and equity markets, will be real. Cross-border production, trade, and tourism will become less costly, if only slightly in most cases. In short, there is a good chance that the start of EMU will be comfortable and economically successful.

The problems will come after the first phase of euphoria and relief. Most economists concur that Europe is not an “optimal currency area,” in which the various regions in EMU will share the same needs of monetary policy. Some regions will be hit by negative shocks that in other times and places would call for monetary ease or currency depreciation. Other regions within EMU will need monetary tightening or currency appreciation. In fact, all will now be straitjacketed by a one-size-fits-all monetary policy. These misalignments are small today, but they will grow over time.

These so-called “asymmetric shocks” and “asymmetric structural problems” would be manageable if Europe otherwise had a flexible and dynamic economy. It does not. Europe is over-taxed and over-regulated in the labor market. Unemployment remains high because Europe cannot afford the job guarantees, heavy payroll taxation, short work weeks, and high-take-home pay (especially for lower skilled workers) that it aspires to. Moreover, Europe neither has the means nor the political cohesion to make up for shortfalls in one region by massive fiscal transfers from other regions (nor would such large transfers generally be a good idea).