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The European Monetary Union once seemed unimaginable. The questions now are What will it lead to? and Will Britain join?
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.
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What will be the effect of the EMU on European economic growth? 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.
What will be the effect on European integration? 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.
The politics of high unemployment have now reversed the governmental shifts of the early 1980s. In France and Germany the socialists Lionel Jospin and Gerhard Schröder have replaced Alain Juppé and Kohl. The transition to Italy's first effective government since the end of the Second World War began on the right but moved left. Outside Euroland, Tony Blair's New Labour defeated John Major's tired Tories.
The overall result is that the EMU -- an institution dedicated to solving the problems of the 1970s using the conservative solutions of the 1980s, which were brought into the 1990s by Maastricht -- is entering the next millennium under the direction of center-left governments.
Therein lies hope. As Mitterrand discovered in 1982, a single small economy cannot stimulate growth while all its competitors are constraining inflation -- later described as the impossibility of "Keynesianism in one country." But the EMU is no small economy, and the new governments, including the UK if it joins, can use the new machinery for the new objectives of increasing growth and reducing unemployment -- which were the old objectives, before the 1970s.
THE new governments and the new machinery face two closely related problems: How to accelerate growth over the long run, and reduce unemployment from the 10-percent-plus rates of the 1990s; and how to keep the shock of an inevitable cyclical downturn from raising unemployment to even higher levels. Two sets of economic policies are available to attack these problems.
Structural policies. One fundamental cause of the long-run problem is structural sclerosis. High taxes to pay for generous social benefits increase the costs of job creation; regulations that make it difficult to fire employees discourage hiring; generous unemployment benefits increase the incentive for recipients to stay unemployed. The consensus among economists and businessmen is that rigidity must give way to flexibility, and dirigisme must be replaced by private entrepreneurship.
Macroeconomic policies. More controversial is the contention that structural change must be supported by a Keynesian stimulus. A number of European economists, and I, argue that only part of the unemployment problem is structural -- that employment and growth in the 1990s have been stymied by too-high interest rates, and that rates should be lowered and kept down. Deficit financing may also be needed, particularly in a deflationary environment or a downturn.
The game that determines the future of Euroland will be played out over time -- political and economic time. Political time is based on electoral schedules: the next national elections in Britain, France, and Germany are scheduled for 2002. This time frame should provide stable center-left governments in the years before the actual substitution of the new currency -- although there is now evidence to suggest that the center-left German coalition led by Gerhard Schröder may be less stable than it seemed in September of 1998, when it came to power.
Economic time is less predictable. Even if the three to four years of political stability are also stable economically, a failure to make significant reductions in 10-percent-plus unemployment will increase pre-election pressure on governments. And if economies turn down, further increasing unemployment, the EMU may be forced to move in directions alien to its inherited conservatism.
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