Euroland, Open for Business

The European Monetary Union once seemed unimaginable. The questions now are What will it lead to? and Will Britain join?

(The online version of this article appears in two parts. Click here to go to part two.)

THE European Monetary Union was born last January 1. Its eleven members, including all the large economies of the European Union except the United Kingdom, which may join in a few years, now have a fixed exchange rate among their currencies and a single monetary policy set by the European Central Bank, in Frankfurt. By July 1, 2002, a single currency, the euro, will have replaced the deutschmark, the franc (Belgian and Luxembourgian as well as French), and the lira.

The change is immensely significant for world prosperity and stability. The gross domestic product of the EMU is nearly equal to that of the United States; if Britain joins, it will be 10 percent larger. "Euroland" -- a favorite name among Germans -- may someday become as politically and militarily powerful as the United States. For the EMU to fulfill its potential, however, some tough questions must be answered.

The short answer is that the EMU will probably facilitate growth, but much depends on events and the policy responses of the union and its members. The EMU was built by conservative governments fearful of active growth policies; it is now responsible to center-left governments anxious to restore growth but afraid to abandon the union's built-in conservatism.

This second answer depends on the first. Prosperity is likely to accelerate integration; economic failure may lead to political disintegration.

A few months after the birth of the EMU I took a trip through Euroland to examine these questions in depth. The answers lie in the history, the economics, and the politics of the nascent confederation.

THE union's economic roots lie in the stagflation of the 1970s. Through the 1960s the central economic objective in Europe, as in the United States, had been full employment. "Keynesian" economic policy was the prescribed instrument: rapid growth, leading to high employment, was to be achieved by keeping interest rates down to encourage business investment and by deficit financing when necessary to fill gaps in private demand. If inflation threatened, interest rates could be raised and budget surpluses substituted for deficits.

The oil-price spiral that began with the Yom Kippur War, in 1973, ended that policy. Burdened by unprecedented energy costs, Western economies could not hold either unemployment or inflation at a satisfactory level. As a result, by the early 1980s the electorates of Britain, Germany, France, and the United States all sought change. Except in France, where the socialist François Mitterrand ousted the rightist Valéry Giscard d'Estaing, left-leaning governments were replaced by the right; the Thatcher-Kohl-Reagan era began. The new rightist finance ministries, aided by their conservative central banks, determined to beat inflation down even at the cost of keeping unemployment high. France under Mitterrand tried the opposite tack but was pulled into line by its European competitors. Average annual inflation in the United Kingdom, Germany, and France fell by about two thirds from the period 1974-1983 to 1984-1991; unemployment increased by anywhere from a third to more than two thirds.

This was the background for the 1991 Maastricht Treaty, which created the EMU. To join the union, applicants were required to "converge" by this year on four criteria: low inflation, a narrow range of interest rates, stable exchange rates, and budget deficits no greater than three percent of GDP. Growth and employment were mentioned only in passing.

The revolution that had swept Eastern Europe two years before, culminating in the reunification of Germany and the end of the Soviet Union, was ignored. Reunification slowed growth in most of Europe, because when Chancellor Helmut Kohl's government incurred large budget deficits to pay for the reconstruction of East Germany, the Bundesbank contained the consequent inflationary pressure by raising interest rates. The depressing effects of the high rates spread across the Continent. Throughout this decade inflation has continued on a downward path, but unemployment has increased even further, rising above 10 percent in France and, somewhat later, in Germany. The UK, having opted out of the EMU, has followed its own policies, which have enabled it to reduce unemployment.

Presented by

Robert A. Levine, an economist with the RAND Corporation, was deputy director of the Congressional Budget Office from 1975 to 1979.

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