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The launch of the euro, though widely praised as a watershed for economic integration, will do little to change underlying conflicts inherent to the European monetary union. The real test will come when Europe faces recession and competing priorities threaten to boil over into disputes over economic sovereignty. The euro will suffer on global markets so long as such political risks remain.
Euro notes and coins hit the streets Jan. 1 without any severe hitches, and the currency received a much-needed boost against the dollar, pound and yen on Jan. 2, the first day of trading. These gains slowed or reversed slightly on Jan. 3 as “europhoria” seemed to begin subsiding.
The physical introduction of the currency – much hyped as “the largest peacetime logistical exercise in history” – was in truth but a small hurdle in the drive toward economic union. The true test will come when Europe faces a prolonged recession. When it does, whether in 2002 or years from now, the euro and the institutions that support it will inevitably come under attack by national political forces preaching a return to economic sovereignty. So long as Europe’s economic union outpaces its political union, uncertainty over the euro’s future will continue to lurk just below the surface.
This uncertainty will create a drag on the eurozone economy and ensure that the U.S. dollar remains the dominant currency for international transactions and financial safekeeping.
The euro has taken a beating on world markets since its introduction as a virtual currency three years ago, falling from $1.1747 when it began trading in 1999 to below 90 cents at the end of 2001. The currency’s weakness was due in part to uncertainty surrounding the newly created European Central Bank and how the ECB’s decisions would affect the eurozone’s disparate economies.
European policymakers are now hoping that the long-anticipated euro rollout will result in a sustained strengthening of the currency. The argument goes that currency markets will now recognize the euro as a full-fledged currency and that there is no turning back. This psychological impact, combined with internal economic benefits like increased price transparency and the disappearance of exchange rate risk, will lead to growing demand for euro notes and coins as well as for euro-denominated financial products. Increasing capital inflows into the eurozone will then generate higher rates of growth – much as the mammoth financial markets act as a growth engine for the United States.
This international recognition is already happening to a certain extent. China plans to issue euro-denominated bonds, and Lithuania will link its currency to the euro in February – but not with the unabashed enthusiasm the European Central Bank would like.
Like the monetary union, the euro is young and immature. It hasn’t been thoroughly tested like the dollar or many of the currencies the euro replaces, such as the mark and the franc. Moreover, the euro’s stability rests in the hands of an organization, the ECB, that must make policy for the good of all while remaining independent from the influence of any. That may be easy when times are good, like steering a ship through calm waters, but it becomes much more difficult in times of economic distress.
The euro’s toughest tests will come when recession grips part or all of the eurozone. Europe lacks the economic synchronization of a single country. As a result, a recession will affect various countries differently, requiring distinct and sometimes conflicting policy responses. What’s good for Germany may not be good for Greece. Somehow the ECB must bridge that gap, taking into consideration a complex array of signals and determining an appropriate and timely response. The ECB has yet to prove its muster in that regard, and this task will become even more difficult with EU expansion.
The ECB’s job is made easier by its limited mandate to guard against inflation. But as the past year has shown, this preoccupation can result in an overly restrictive monetary policy. Unless inflation is very near the union’s 2 percent ceiling, interest rate cuts will be hard to come by, especially if they are needed to spur growth only in certain countries.
That puts European politicians in a very tough spot. Unlike the technocrats at the ECB, they must answer to the voters, very few of whom think of themselves primarily as Europeans. Few would be willing to sacrifice their own prosperity for a fellow European in a distant country.
The ECB and the euro have yet to face the test of a sharp economic downturn that pits one eurozone economy against another, though that may happen if Germany doesn’t begin growing soon. Whenever recession hits, the nationalists are sure to come out of the closet – people like Italian Reforms Minister Umberto Bossi, head of the right-wing Northern League, who said, “Personally, I couldn’t care less about the euro and I don’t think it means anything to anybody else either,” Reuters reported Jan. 2. At such times, the stresses on the ECB and the euro will be great, and it is impossible to know how they will respond.
In the end a currency’s long-term value is determined by the economic fundamentals and political stability of the issuing country. Thus, the stable and prosperous United States has a strong dollar while the economically moribund and politically impotent Japan has an ever-weakening yen.
The euro appears destined to fall somewhere in between, benefiting from the economic size and strength of the eurozone but limited by the political instability inherent to a union of sovereign countries. As a result the euro will fail to gain significant ground against the dollar, much less challenge it as the world’s preferred hard currency.
In that sense, the latest euro triumph is mostly mechanical. More difficult tests are yet to come.