Key Questions Require Answers As EMU Moves Toward Reality

THE WALL STREET JOURNAL - Dec. 29, 1997

PARIS -- Europe's planned common currency is no joke. That's official.

When Luxembourg's prime minister, Jean-Claude Juncker, sent out a letter to his European Union counterparts earlier this month, he wrote that Economic and Monetary Union starts on April 1, 1999. A few hours later, he issued an embarrassing correction: EMU starts on Jan. 1, not on April Fools' day.

Until recently, Mr. Juncker's slip of the pen would have seemed to many an apt metaphor for Europe's bold currency plan: A lot of Europeans lent as much credence to politicians' repeated claims that EMU would start on time as they did to April Fools' jokes.

But in recent weeks, all remaining doubts appear to have vanished. The remarkable degree of economic convergence between European nations and the steely determination of Europe's leaders have convinced all but the most skeptical not only that EMU will start on schedule, but also that it is likely to include all of the EU's 15 countries except for Britain, Sweden and Denmark -- which don't want to join -- and Greece, which falls short of the requirements. "We're ready for EMU," proclaims French Finance Minister Dominique Strauss-Kahn.

Growing Doubts

At the same time, however, a funny thing is happening: While EMU has never seemed more certain, Europeans have never had more doubts about the huge leap they're about to take. A recent pan-European poll by the EU's executive commission showed that support for the euro, as the common currency is to be called, is now running at 47% -- the first time the pro-EMU camp has polled less than 50% since the Maastricht treaty on monetary union was signed in 1992.

These doubts underscore the growing realization in Europe that if getting to the EMU starting line was hard, making it work will be even harder. For EMU is a gigantic, real-life crapshoot. Never before has such an undertaking been tried: Almost a dozen nations will simultaneously throw out their currencies and willingly cede their monetary sovereignty to an independent, pan-European central bank. "It's uncharted waters," says Norbert Walter, chief economist of Deutsche Bank AG in Frankfurt. "We're on a discovery route. It's nothing short of revolutionary."

If it works, the world economy will change. Nearly all of Europe will become a fully integrated market of almost 300 million consumers, and doing business across national boundaries will be as easy as between Texas and California. The euro will challenge the dollar's dominance of world trade, and Europe will gain real economic and political clout.

'We're Not Ready'

But there's a huge downside too. Binding together different economies could lead to deflation, higher unemployment, social turmoil and a rise of nationalism, some warn. "Monetary union is a fabulous idea, but it's clear we're not ready," says Noel Goutard, chairman of French autoparts maker Valeo SA. "Three years after its launch, we're going to be wondering why we got into this."

As EMU moves inexorably from the drawing boards to reality, Europeans are waking up to the huge changes it means -- and to the work needed to make it a success. For monetary union doesn't simply mean going from francs or marks or pesetas to euros; it also means developing coordinated economic policies, taking steps to avoid predatory competition between states on taxes or labor costs, and devising new political and economic rules for an entire continent. "To make EMU a success, there's a heavy agenda of open questions," says Mr. Walter. Anxious to avoid frightening their voters, European leaders have played down many of these issues. Some could spark serious tensions within European societies or between countries, as current debates over who should run Europe's central bank and how to arrange relations between the EMU ins and outs show. What follows is a glimpse at Europe's agenda for the coming months -- key questions that need to be addressed to make a success of one of the most dramatic economic transformations ever attempted.

• Can there be a one-size-fits-all monetary policy?
  
  EMU doesn't just mean a common currency; it also means a common monetary policy for all participating nations. But what is the right interest rate for all? Is what's right for Germany or France also right for Ireland or Spain?
  
  True, aspiring EMU entrants look remarkably similar: All the EMU candidates meet stringent low-deficit, low-inflation entrance requirements. Even once-profligate Italy is now among Europe's most economically virtuous nations; its 1997 inflation rate of 1.6% is even lower than Germany's.
  
  But this statistical convergence belies economic divergence. Ireland's 7.7% growth this year has some calling it "the Celtic dragon." But growth in Italy will be a lowly 1.3% this year, while France and Germany are growing at a sluggish 2.5%. Irish short-term interest rates are at 6.75%; French, German and Belgian ones are at 3.3%.
  
  So where should Europe's interest rates be set? Senior monetary officials in key countries are adamant that the lowest benchmark rates in Europe should prevail, rather than an average of national rates. But while that would ensure that the slow-growing countries -- coincidentally, mostly Europe's biggest economies -- aren't punished by EMU, it spells problems for the fast-growing ones.
  
  Indeed, many argue that Ireland really needs to hike rates; instead, to join EMU, it will have to cut them by up to three percentage points. That could trigger inflation.
  
  For now, Irish officials and economists appear unconcerned. "We'll have to make do with whatever happens," says Patrick Honohan of the Economic and Social Research Institute in Dublin. But economists say the country will have to make some tough choices: either revalue the Irish pound, which could damp Irish competitiveness, or tighten fiscal policy.
  
  The Bundesbank's surprise decision in October to raise its short-term rate to 3.3% from 3% shows the difficulty of setting a Euro-zone interest rate. When France -- like Belgium, the Netherlands, Austria and Denmark -- quickly followed suit in what many saw as a dress rehearsal of pan-European monetary policy, an uproar erupted in Paris. The central bank's policy council was summoned by the National Assembly's finance commission to justify the move. Even former EU Commission President Jacques Delors blasted the action. "How can public opinion understand a tightening of monetary policy when the acceleration of growth is not yet tangible?" he asked. "We have an unemployment problem, not an inflation problem."
   
• Where's the emergency exit?
  
  The year is 2003. The U.S. goes into recession. Housing starts fall 26%. Demand for wood plummets, sending the forestry industry into a tailspin. Prices for wood and related products fall 15%.
  
  That's a nightmare for Finland, where the pulp-and-paper industry accounts for 40% of total exports and employs 18% of the work force. Its budget deficit rises to 4% of gross domestic product.
  
  And this turns into a major crisis for Europe. Finland threatens to withdraw from EMU unless it is allowed to spend its way out of recession, widening its budget deficit further. But under the German-inspired stability pact linking EMU members, budget deficits can't exceed 3% of GDP, except in exceptional circumstances. What to do?
  
  This fictional scenario, imagined by Patrick Artus, chief economist of the Caisse des Depots et Consignations in Paris, goes to the heart of a big problem with EMU: "It's condemned to succeed, and if it doesn't, we're condemned," quips former Italian Foreign Minister Antonio Martino.
  
  The stability pact keeps EMU participants in a straitjacket, and calls for fines for countries that exceed the budget-deficit ceiling -- which could aggravate recessions. But there are no instruments to counter recessions.
  
  In the U.S., when one region is hit by an economic shock, the federal government helps by redistributing taxes. But there is no federal European government, and the EU's budget amounts to a paltry 1.27% of the bloc's GDP. "The Maastricht treaty doesn't envision a financial-assistance mechanism in case of accident in a country," Bundesbank chief economist Otmar Issing said recently. "At the European level, there is no political will to pay even more for other states."
  
  And with labor mobility restrained by language and regulatory barriers, Europeans can't escape recession by moving as easily as in the U.S. And there's no escape from EMU. "You're abolishing national currencies and you can't bring them back," says Christopher Potts, chief economist at Cheuvreux de Virieu, a Paris brokerage house. "You've burned all your bank notes."
  
  Many analysts say that EMU must be made more flexible. Mr. Artus suggests that the 3% deficit ceiling be set for Euro-land as a whole, not for a specific country. But others say that could lead traditionally more profligate states to seek a free EMU ride, getting the benefits of lower interest rates without maintaining fiscal rectitude.
  
  Though the problem of specific shocks like the Finnish scenario applies mainly to smaller, less-diversified countries, failure to address this issue could lead to "a catastrophe," warns French economist Jean-Paul Fitoussi. Since most countries will be entering EMU with deficits close to the 3% ceiling, an economic slowdown could lead them to test EMU's flexibility fairly quickly, he says. "The big question is: How will we manage this if there is a recession or a shock?"
   
• Can a monetary union work without closer economic and political union?
  
  The union remains divided by 15 different tax systems. Luxembourg, for example, has built a huge offshore-banking industry by imposing no withholding tax on savings. Ireland's 10% corporate tax for multinational companies has made it a prime location for foreign investment. Can that continue after EMU? Many think not. "Nothing will be like before," Italian Prime Minister Romano Prodi said recently. "Currency integration can only lead to ever-closer integration of economic policies between different countries."
  
  Indeed, EMU will act as a revealer of inefficiencies and differences previously hidden by exchange rates. With devaluations -- which could wipe out gains -- eliminated by EMU, the field will be level and competition between countries to attract investment and jobs will become intense. And unless EMU countries agree on closer harmonization of taxes, labor costs and welfare systems -- while maintaining a degree of rivalry -- that competition could be predatory.
  
  The question is: At which level should they converge? If countries align themselves on the lowest rates, tax receipts fall and the European welfare state is threatened. But aligning themselves on high-cost countries like Germany or France, which is seeking to impose a 35-hour workweek even as it enters EMU, could perpetuate Europe's declining competitiveness.
  
  In a first breakthrough, EU finance ministers last month agreed to a nonbinding code on corporate taxation under which they will end tax breaks for specific sectors or regions over five years.
  
  But many say that's a timid first step. "If we don't have closer harmonization, we will simply replace competitive currency devaluations with social-protection devaluations," says French banker Olivier Klein. "That's tomorrow's burning issue."
   
• Who runs Europe?
  
  "When I need to talk to Europe, who do I call?" Henry Kissinger once reportedly asked. Try the European Central Bank. "The governor of the European Central Bank will be the most powerful man in Europe," says French economist Gerard Lafay.
  
  Indeed, not only will the Frankfurt-based monetary institution inherit the powers ceded by national central banks, but its decisions will have a huge impact on almost 300 million Europeans -- and on global financial markets. That partly explains France's determination to get its central bank governor, Jean-Claude Trichet, named over Germany's candidate, Dutchman Wim Duisenberg.
  
  But many Europeans are concerned that so much power is being handed to unelected officials. "Europe isn't designed to be managed by a European central bank; it's designed to be run by a political authority," says former French Prime Minister Edouard Balladur. In the absence of a federal government, however, "EMU will begin with a remarkable institutional imbalance," says Jurgen von Hagen, director of the Center for Research on European Integration at Bonn University. "The only institution responsible for policy on a European level will be the European Central Bank." Moreover, the pan-European bank's mandate is very narrow -- defending price stability -- and it will be far less accountable than the U.S. Federal Reserve Board is.
  
  To counter the central bank's power, France and others want to form a council of EMU members that would serve as a policy-coordination forum. Supporters of the idea say it will not only make EMU more democratic, but also will help ensure that the central bank doesn't take all the blame if Europe's economies perform poorly. But others fear that such a council could result in political pressure on the central bank -- a charge France's Mr. Strauss-Kahn vehemently denies.
  
  Still, he and others argue, if EMU is at root a political venture, designed to foster closer European integration, it needs political legitimacy. And many feel that the whole EMU process has been short of democratic debate and has sought to minimize the risks it entails. "The euro is being introduced coercively," says Italy's Mr. Martino. "To start a currency with this situation of distrust is to play with fire."
  
  To be sure, the questions raised by EMU are often complex and don't lend themselves easily to debate. But many fear that if it doesn't quickly prove to be a useful tool to promote growth and employment in Europe, EMU could be questioned -- and the governments who promoted it could be ousted. Says French Labor Minister Martine Aubry: "With the euro, you're either in or out. On the employment issue, it's governments that will be in or out."