Beyond the Border

Five Years of the : Successes and New Challenges

urope embarked upon monetary past five years, with most of the poor not yet members because they only union much the way Columbus performance arising from structural joined the EU earlier this year. (See map E set out across the Atlantic in rigidities in product and labor markets. on page 15.) 1492—full of hope but without a map. The first five years of the euro also saw Economists and European central Nothing like economic and mone- instability in the currency’s value. In bankers recently gathered at the Federal tary union (EMU) had ever been tried 1999 and 2000, the euro fell against the Reserve Bank of Dallas to assess the first before its launch in 1999. Eleven coun- dollar, reaching a low of 82 cents in five years of the euro. Presentations tries—with a hodgepodge of languages, October 2000. After 2002, the currency focused on the currency’s international cultures and customs—tied their eco- rose, peaking at $1.28 in February 2004. role, its impact on global financial mar- nomic futures to a common central bank Various explanations, including higher kets, the lessons learned and the chal- and single currency, the euro. Greece U.S. productivity, do not fully account lenges ahead. This article draws on con- joined in 2001, expanding the euro zone for the exchange rate swings, which are ference presentations to review EMU from to 310 million people in 12 nations. no worse than the dollar’s earlier ups the perspectives of various countries.1 After five years voyaging into the un- and downs against the German mark known, the (EU) may not and Japanese yen. Fringe Players: have discovered a new world of pros- Twelve of the 25 EU member states Ireland and Portugal perity, but it at least proved wrong the currently participate in EMU, whose EMU gets its ballast from core heavy- pessimists who doomed EMU even before framework was established by the Maas- weights France and Germany, but the its launch. Bank of France Governor tricht Treaty of 1991. Some are not par- single currency involved leaps of faith Christian Noyer summed up what many ticipants because they choose not to be. for Ireland and Portugal, two smaller had predicted for EMU: It will never hap- and the United Kingdom, for countries on the EU’s periphery. They pen. If it does happen, it will be a disaster. example, negotiated opt-out clauses to could have stayed out, like Britain, Swe- EMU has confounded those expecta- the treaty, which obliges EU members to den and Denmark, but chose to join, tions by establishing itself without any adopt the single currency when they becoming integral parts of the European major breakdowns—in iffy times for the meet the qualifying criteria. Others are economy. global economy. The (ECB) has built a reputation as an independent, credible monetary author- ity. And the euro ranks as the world’s Chart 1 second most important international cur- Inflation Under EMU rency, after the dollar. Percent (year-over-year) Perhaps most important, the new 3.5 monetary arrangement has achieved its primary goals—macroeconomic stability 3 and, more specifically, low inflation. The ECB has defined price stability as con- 2.5 sumer inflation of less than 2 percent. 2 And as Chart 1 shows, EMU has largely de- ECB target livered on that mandate. Tame inflation 1.5 has given most member countries both short- and long-term interest rates lower 1 than they would otherwise have had. Monetary union has not been as suc- .5 cessful in stimulating the economies of 0 continental Europe. Chart 2 shows that 1999 2000 2001 2002 2003 2004 the euro area has grown more slowly SOURCE: Statistical Office of the European Communities. than the United States for much of the

FEDERAL RESERVE BANK OF DALLAS SOUTHWEST ECONOMY JULY/AUGUST 2004 13

Chart 2 Economic Growth in the United States and Euro Area GDP (percent)* 6

5 United States 4

3

2

1 Euro area Fundamental to 0 –1 EMU’s success in 1999 2000 2001 2002 2003 2004 *Seasonally adjusted, annualized rate. Portugal has SOURCES: Office of the European Communities; U.S. Bureau of Economic Analysis. been widespread recognition that In its first five years under EMU, Ire- expansionary fiscal policy helped stoke long-term land achieved one of its primary goals— the fires under wages and asset prices. closing the credibility gap that saddled Entering EMU, Portugal received the changes have its economy with borrowing costs above same credibility boost Ireland did, bring- been made to the Germany’s. Had it not entered EMU, Ire- ing greater stability and lower interest land would almost certainly have ended rates. Consumers’ incomes, firms’ cash economy. up with higher interest rates than it has. flows and the state’s fiscal operations are They would have choked off the nation’s all in , the same currency those 1990s growth spurt, a boom captured in agents are borrowing and lending in the the description of Ireland as the “Celtic domestic and foreign markets. Tiger.” Operating in euros provides Portu- In other ways, EMU membership gal with certainty in its economic rela- hasn’t turned out as expected. Perhaps tions with the rest of the world. With a most significant, Irish inflation acceler- national currency, jitters about trade ated following EMU’s launch, rather than imbalances and central bank reserves fed retreating to the euro zone average. This into exchange rate and pan- was partly due to the Irish market’s ics, causing problems for Portugal’s sol- heavy reliance on British retailers, whose vent as well as its insolvent. When it pricing decisions reflect economic condi- comes to creditworthiness, families, firms tions outside EMU. With interest rates and government entities are now judged lower, the Irish saw the EU’s biggest on their own merits, not by conjectures building boom, marked by double-digit about the national economy. By giving increases in housing prices and rising Portuguese companies greater access to construction costs. international finance and removing As an EMU member, Ireland can no exchange rate risks, the single currency longer rely on monetary policy to cool created a surge in overseas investment inflation, leaving the budget as the pri- for a nation once isolated economically. mary lever for keeping excess demand Fundamental to EMU’s success in from driving up prices. EMU member- Portugal has been widespread recogni- ship requires adherence to the so-called tion that long-term changes have been Stability and Growth Pact, which limits made to the economy. This allowed governments’ ability to run budget nominal and real interest rates to fall to deficits. Like several other EU nations, the EU average. Families and firms could Ireland has run afoul of the pact’s guide- then borrow more without assuming lines in recent years. The country’s higher debt service. Households’ total

14 FEDERAL RESERVE BANK OF DALLAS SOUTHWEST ECONOMY JULY/AUGUST 2004

Europe 5 Years Into Monetary Union

ICELAND

SWEDEN FINLAND

NORWAY RUSSIA

ESTONIA

IRELAND DENMARK LATVIA

LITHUANIA

UK

NETH. BELARUS GERMANY BELGIUM LUX.

CZECH REPUBLIC UKRAINE

SLOVAKIA FRANCE SWITZERLAND AUSTRIA MOLDOVA SLOVENIA

PORTUGAL BOSNIA and HERZ. YUGOSLAVIA SPAIN

ITALY MACEDONIA

ALBANIA

GREECE TURKEY

EMU nations CYPRUS Long-time EU members not in EMU MALTA 10 new EU members

credit increased from 46.4 percent of On the Sidelines: growth, trade and incoming investment, GDP in 1996 to 103.7 percent in 2002. At Great Britain and as well as a boost for financial services. the same time, borrowing by nonfinan- While Ireland and Portugal joined But the government continues to worry cial companies rose from 53.7 percent to EMU, two other nations on Europe’s that UK business cycles aren’t in sync 92.1 percent of GDP. fringes geographically opted out, retain- with the EU’s and that EMU rules lack As in Ireland, EMU has raised ques- ing control of their own monetary poli- the flexibility needed to respond to the tions about whether falling interest rates, cies and keeping their own currencies. British economy’s ups and downs. coupled with budget deficits, have pro- Some British euroskeptics believe While the EMU nations spent the 1990s duced too much of a good thing. The the United Kingdom will never join the preparing for the euro, the UK enjoyed a signs are there—current account deficits, euro zone. Indeed, the UK Indepen- decade of steady growth with tame infla- inflation above the EU average, rising dence Party, which favors withdrawal tion. Britain’s economy continued to out- asset prices. A more benign view of from the EU, gained ground in recent perform the euro area’s during the past these developments is that they reflect elections. five years, as Charts 3 and 4 show. market-led responses to the transition to In its latest assessment of EMU mem- Economic models suggested that EMU that will unwind without causing bership, issued in 2003, the British gov- signing onto EMU would have made for many problems. ernment notes potential advances in a far bumpier ride, three-quarters of it

FEDERAL RESERVE BANK OF DALLAS SOUTHWEST ECONOMY JULY/AUGUST 2004 15

Chart 3 Inflation in the United Kingdom and Euro Area Percent (year-over-year) 3.5

3

2.5 Euro area 2

1.5

1 United Kingdom As a latecomer in .5 0 deciding whether 1999 2000 2001 2002 2003 2004 to join, Sweden SOURCE: Statistical Office of the European Communities. had the advantage tied to the exchange rate of the euro and Whereas Britain long opposed enter- of looking at the dollar. The last thing many skeptics ing EMU, Sweden’s political elite wanted wanted was to risk the UK’s stability. the country to join. Swedish voters re- experiences of Joining the euro zone, moreover, would jected the idea in a September 2003 ref- not produce other tangible gains. Lower erendum, unpersuaded that potential other countries transaction costs for changing money gains from adopting the euro would out- both inside and would be offset by the cost of switching weigh the loss of independence in mon- from pounds to euros. Fluctuating etary policy and the risk of economic outside EMU. exchange rates would remain a risk, shocks. Charts 5 and 6 compare Swe- given Britain’s trade patterns. The coun- den’s inflation and growth with those of try divvies up its trade between the blocs the euro area as a whole. dominated by the euro and the dollar. As a latecomer in deciding whether Joining EMU would eliminate risks with to join, Sweden had the advantage of the former but increase them against the looking at the experiences of other latter. countries both inside and outside EMU.

Chart 4 Economic Growth in the United Kingdom and Euro Area GDP (percent)* 5

4.5

4

3.5

3 United Kingdom 2.5

2

1.5

1 Euro area

.5

0 1999 2000 2001 2002 2003 2004

*Seasonally adjusted, annualized rate. SOURCE: Statistical Office of the European Communities.

16 FEDERAL RESERVE BANK OF DALLAS SOUTHWEST ECONOMY JULY/AUGUST 2004

Chart 5 Inflation in Sweden and the Euro Area Percent (year-over-year) 3.5

3

2.5 Euro area 2

1.5 Sweden

1 .5 The big risk in 0 1999 2000 2001 2002 2003 2004 joining EMU lies in SOURCE: Statistical Office of the European Communities. vulnerability to Europe-wide The evidence suggests that joining the tries with higher inflation need tighter euro zone might increase trade by 10 to money—but may get the opposite. policies that aren’t 15 percent. Gains from lower transac- Countries trying to climb out of sluggish tions costs are small. Like Britain, Swe- spots need looser policies—but may get appropriate for an den would face exchange rate risks even the opposite. If Sweden’s economy were inside EMU because of its significant to fall out of step with the rest of Europe, individual country’s trade with countries outside the euro the common interest and exchange rate economic conditions. zone. Joining EMU might produce lower would have a destabilizing effect. inflation, cheaper credit and stable Outside EMU, Sweden can use both exchange rates, but they can also be monetary and fiscal policies to manage achieved with sound domestic policies. its economy. Inside, fiscal policy be- The big risk in joining EMU lies in comes the primary lever, and govern- vulnerability to Europe-wide policies that ment spending isn’t always a good sub- aren’t appropriate for an individual stitute for monetary policy. country’s economic conditions. Coun-

Chart 6 Economic Growth in Sweden and the Euro Area GDP (percent, year-over-year) 6

5

4

3

Sweden 2

1 Euro area

0 1999 2000 2001 2002 2003 2004

SOURCE: Statistical Office of the European Communities.

FEDERAL RESERVE BANK OF DALLAS SOUTHWEST ECONOMY JULY/AUGUST 2004 17

EMU now that it has established the euro Table 1 zone. In its first five years, EMU did not European Union Newcomers Will Have to Work for EMU Entry fall prey to pessimists’ worst fears, and it kept inflation under wraps. Ireland and Inflation Long-term Portugal did benefit from lower interest rate interest rate Fiscal deficit Public debt (May 2004) (2004:1) (2002) (2002) rates, but EMU failed to ignite growth in Cyprus 1.2% 4.71% –3.5% 58.6% the larger member nations. Economic 2.6 4.24 –3.9 27.1 disparities and impediments still plague Estonia 3.7 4.94 1.3 5.8 the EU, and the structural reforms to Hungary 7.8 7.17 –9.2 56.3 address them haven’t been achieved. Latvia 6.1 4.95 –2.0 22.7 Perhaps most important, the EU will Lithuania 1.0 5.16 –3.0 15.2 continue to wrestle with the inherent Malta 2.4 4.91 –6.2 66.4 contradictions between a centralized Poland 3.5 5.96 –4.1 41.8 monetary policy and decentralized fiscal Slovakia 8.2 5.01 –7.2 42.6 policies. Before the 2001 recession, Slovenia 3.9 6.14 –2.6 28.3 nations did not get their budgets into cyclical balance, and they ran into trou- Target 2.7 6.27 –3.0 60 ble when times turned tougher. Ger- NOTES: Boldface numbers indicate areas in which countries do not meet the target. Fiscal deficit and public debt are as a percentage of GDP. many’s and France’s deficits now exceed Inflation and interest rate targets change with underlying economic conditions; those shown are for early 2004. the limit of 3 percent of GDP. The SOURCES: Statistical Office of the European Communities; Malta National Statistics Office. deficits aren’t as large as in previous downturns, but EMU’s only leverage under the Stability and Growth Pact amounts to peer pressure, which hasn’t Knocking on the Door: Malta has a public debt above the worked. The real danger of deficits lies New EU Members threshold of 60 percent of GDP. in overheating the economy, creating The EU’s recent expansion brought Rigid adherence to the targets may bubbles that will cause job losses and into the fold 10 countries, most of which be unwise when it comes to the 10 new- falling asset prices when they burst. were part of the communist bloc only 13 comers. These standards were devel- Past attempts at currency unions or 14 years ago. So even before they’ve oped for established market economies, eventually faltered because of their fail- grown comfortable with capitalism, they not countries in transition. Flexibility ure to enforce fiscal discipline. How face another round of restructuring tied aimed at hastening entry could spare EMU handles fiscal policy might be just to joining EMU. these countries some hard times. The EU as important as how it directs the conti- These newcomers can’t opt out of might, for example, alter the target infla- nent’s monetary affairs. monetary union, so key issues boil down tion rate from the average of the three —Richard Alm to timing and preparation. Some econo- best performers to the euro zone aver- mists recommend entry into the euro age. In any case, experience suggests Alm is an economics writer in the Research zone as soon as possible to capture the prices stabilize quickly after entry. Get- Department of the Federal Reserve Bank benefits of price stability and lower in- ting the fiscal house in order should be of Dallas. terest rates. The newcomers are already the primary concern, and all the new- integrated with the rest of Europe, mak- comers, save the Czech Republic, expect Notes ing them vulnerable to the shocks and to do that by next year. 1 “Five Years of the Euro: Successes and New Challenges” was held credibility premiums that once bedeviled The goal is to bring the 10 newcomers May 14–16, 2004. The conference was organized by the Dallas Fed into EMU between 2007 and 2010, but and the University of Texas at Austin and sponsored by the Commis- two other small nations, Ireland and Por- sion of the European Communities. Information on participants and tugal. Euro enthusiasts see national cur- no dates have been fixed. As early as their presentations can be found at www.dallasfed.org/news/ rencies as a luxury these 10 countries 2005, each country will enter a transi- research/2004/04euro.html. can no longer afford. tional phase in which the national cur- Joining will depend on meeting rency is fixed against the euro. A mini- EMU entry criteria. As Table 1 shows, all mum of two years later, the countries the newcomers have work to do. The will fully adopt the euro. The strategies biggest hurdles are getting inflation to a of the newly admitted countries put target within 1.5 percentage points of the Estonia, Latvia, Lithuania and Slovenia EU’s three best performers and reducing into transition in 2007. Poland, Hungary fiscal deficits to 3 percent of GDP. Only and Slovakia may enter in 2008 or 2009; Hungary fails to meet the standard for the Czech Republic may be ready in long-term interest rates, a target that is 2009 or 2010. within 2 percentage points of the EU Incorporation of the new states will members with the lowest inflation. Only be among the important tasks facing

18 FEDERAL RESERVE BANK OF DALLAS SOUTHWEST ECONOMY JULY/AUGUST 2004