Webcast Transcript Listen to the Webcast View the Webcast Q1. What is the Euro? The euro is a currency unit now used by 11 of the 15 member states of the European Union - these 11 states are now members of what is often referred to as the euro-zone. The establishment of the euro has rightly been described as an amazing political feat. There are few historic precedents for what the Europeans are doing. Establishing the euro required the participating national governments not only to give up their own currencies, but also to give up control over monetary policy. Governments are not routinely in the habit of giving up control over important economic policy instruments - of sacrificing national sovereignty for the greater good - so perhaps this should give you a sense of the importance that the Europeans attach to the euro. By adopting the euro, the EU has created the second largest currency zone in the world after that of the U.S. dollar. Indeed, there are some who believe that ultimately, the euro could come to rival the dollar in importance as the most important currency in the world. The euro was born on January 1st, 1999 when the exchange rates between the national currencies of the 11 participating states - which include Germany, France, Spain, Holland, and Italy - were "locked in" against each other. For the time being, Britain, Denmark and Sweden have decided not to adopt the euro. Greece did not meet economic criteria for adoption required by the EU. Euro notes and coins will not actually be issued until January 1st, 2002. In the interim, national currencies will continue to circulate in each of the 11 countries. However, in each participating state the national currency will stand for a defined amount of Euros. In other words, notes that now look like French francs, or German deutschmarks, or Italian lira, are in reality mere denominations of the Euro. In each participating state, banks and businesses will now start to keep two sets of accounts, one in the local currency and one in euros. Many prices are now posted in both euros and the local currency. And increasingly, many business transactions will be conducted in euros. After January 1st, 2002, Euro notes and coins will be issued and the national currencies will start to be taken out of circulation. After about six months, only euros will be in circulation - and all prices and routine economic transactions within the euro zone will be in euros. In effect, after January 1st, 2002, the euro will move from being a virtual currency to a real currency. Q2. You mentioned that Greece did not meet the economic criteria for adoption of the Euro required by the EU. What criteria did countries have to meet in order to be included in the Euro-zone? To join the Euro zone member countries had to achieve low inflation rates, low long term interest rates, a stable exchange rate, public debt limited to no more than 60% of a country's Gross Domestic Product, and current budget deficits of no more than 3% of GDP. The thinking here was that if the economic fundamentals of the economies in the Euro-zone were strong, and convergent, it would be relatively easy to manage the introduction of the Euro, particularly during the three year transition period between January 1st, 1999 and January 1st, 2002. Initially there was considerable skepticism that it would be possible for European countries to attain these goals. However, by the Spring of 1998 it was clear that of the 12 countries that had singled their intention to join the Euro zone, only Greece would not make the criteria. The Greeks believe that they are on track to join by 2002. They have already got their inflation rate down to 3.9% (in December 1998) and their budget deficit is now 2.2% of GDP. Q3. How is monetary policy to be managed within the euro-zone? A transnational currency requires a transnational authority to manage monetary policy, so the European Union created a European Central Bank (ECB) to manage monetary policy within the euro zone. The ECB was formally established on June 1st, 1998. In order to minimize political interference the ECB has been set up as an independent institution - rather like the Federal Reserve in the United States. The ECB has been charged with maintaining price stability within the euro zone, which effectively has been translated to mean an inflation rate of 2.0% or less. The ECB will manipulate interest rates in order to help attain this goal. Fortunately for the ECB, Europe is currently experiencing its lowest inflation rate in fifty years, making the task of managing the transition period until 2002 far easier than it might otherwise have been. Q4. Why have the Europeans decided to establish the euro? What are the benefits of doing so? The genesis of the euro can be traced to the late 1980s, when in a series of papers the French finance minister and German foreign minister floated the idea of a single European currency and a European central bank as a necessary complement to a single European market. Back in 1987, the member states of the European Community agreed to establish a single European market by December 31st, 1992. In December 1991, the leaders if the EU's member states met in Maastricht, which is in the Netherlands, to discuss the proposal for a common currency to complement the single market. The result was the Maastricht treaty, which among other things committed the EC to establish a single currency by 1999. There are a number of reasons why the Europeans decided to take this step. First, they believe that business and individuals will realize significant savings from having to handle one currency, rather than many. These savings come from lower foreign exchange and hedging costs. For example, an individual going from Germany to France will no longer have to pay a commission to a bank in order to change Deutschmarks into Francs. Instead, they will be able to use euros. According to the European Commission, such savings could amount to 0.5% of the European Union's GDP, or about $40 billion per annum. Second, and more importantly in my view, the adoption of a common currency will make it easier to compare prices across Europe. This should increase competition because it will be much easier for consumers to shop around. For example, if a German finds that cars sell for less in France than Germany, they may be tempted to purchase from a French car dealer rather than their local car dealer. Alternatively, traders may engage in arbitrage to exploit such price differentials, buying cars in France and reselling them in Germany. The only way that German car dealers will be able to hold onto business in the face of such competitive pressures, will be to reduce the prices they charge for cars. As a consequence of such pressures, the introduction of a common currency should lead to lower prices across the board. This should translate into substantial gains for European consumers Third, faced with lower prices European producers will be forced to look for ways to reduce their production costs in order to maintain their profit margins. To the extent that this occurs, so the argument goes, the introduction of a common currency, by increasing competition, should ultimately produce long run gains in the economic efficiency of European companies. Fourth, the introduction of a common currency should give a strong boost to the development of highly liquid pan-European capital market. The development of such a capital market should lower the cost of capital and lead to an increase in both the level investment, and the efficiency with which investment funds are allocated. This could be especially helpful to smaller companies that have historically had difficulty borrowing money from backward domestic banks. For example, the capital market of Portugal is very small and il liquid, which makes it extremely difficult for bright Portuguese entrepreneurs with a good idea to borrow money at a reasonable price. However, in theory, entrepreneurs and such companies in general, should soon be able tap a much more liquid pan-European capital market. For example, right now Europe has no continent wide capital market, such as the NASDAQ market in the United States, that funnels investment capital to dynamic young growth companies. The introduction of the euro could greatly facilitate the establishment of such a market. The long run benefits of such a development should not be underestimated. Finally, the development of a pan-European euro denominated capital market will increase the range of investment options open to both individuals and institutions. For example, it will now be much easier for individuals and institutions based in, let's say Holland, to invest in Italian or French companies. This will enable European investors to better diversify their risk, which again lowers the cost of capital, and should also increase the efficiency with which capital resources are allocated. Q5. Are there any drawback associated with the introduction of the Euro? There may be drawbacks associated with the introduction of the Euro. Certainly, many people in Britain, Denmark and Sweden feel that the Euro has a substantial downside, which is why none of these countries have yet joined the Euro-zone, even though all three are in the European Union. One perceived drawback of a single currency is that joining the Euro-zone requires national authorities to give up control over monetary policy, such as interest rates, to the European Central Bank. The implied lose of national sovereignty underlies the decision by Britain, Denmark and Sweden to stay out of the Euro-zone for the time being. In these countries, there is a strong body of opinion that is highly suspicious of the ability of the ECB to remain free from political pressure, and to keep inflation under tight control. Having said this, one must acknowledge that in theory at least, the design of the ECB should ensure that it remains free of political pressure. The ECB is modeled on the German Bundesbank - which historically has been the most independent and successful central bank in Europe. The language contained in the Maastricht treaty prohibits the ECB from taking orders from politicians. The executive board of the bank, which consists of a president, vice president, and four other members, will carry out policy by issuing instructions to national central banks. The policy itself will be determined by the governing council, which consists of the executive board plus the central bank governors from the 11 Euro-zone countries. The governing council will vote on interest rate changes. Members of the executive board are appointed for eight year non-renewable terms, insulating them from political pressures in order to get reappointed. Nevertheless, the jury is still out on the issue of the ECB's independence, and it will take some time for the bank to establish its inflation fighting credentials. According to critics, another drawback of the Euro is that the EU is not what economists would call an optimal currency area. An optimal currency area is an area where similarities in the underlying structure of economic activity make it feasible to adopt a single currency and use a single exchange rate as an instrument of macro-economic policy. Many of the European economies in the Euro-zone, however, are very dissimilar. For example, Finland and Portugal are very dissimilar economies. The structure of economic activity within each country is very different. They have different wage rates and tax regimes, different business cycles, and may react very differently to external economic shocks. What this implies that a change in the Euro-exchange rate that helps Finland may actually hurt Portugal. Obviously, such difference complicate macro-economic policy considerably. For example, when Euro economies are not growing in unison, a common monetary policy may mean that interest rates are too high for depressed regions, and too low for booming regions. Actually, the EU may have to grapple with such a problem very soon. The economic growth rates of the euro-zones two biggest economies, France and Germany, are currently diverging. In 1998, France's GDP grew by 2.8%, while Germany grew by only 1.8%. Moreover, while growth in France continues to remain strong, the German economy seems to be slowing. This suggests that perhaps interest rates should be higher in France, to keep growth and hence inflation pressures in check, and lower in Germany to kick start its stagnating economy. However, the ECB can only set a single interest rate for the entire euro-zone, so we may end up with an interest rate that is too high for Germany, and too low for France. It will be interesting to see how the EU copes with the strains caused by such divergent economic performance. Of course, one could argue that the U.S. also has to cope with similar problems, since the economic performance of its various states often diverge. Yet the U.S. has successfully managed such problems for generations - so why shouldn't the EU? After all, the U.S. is not an optimal currency area either. The structure of the economy in Louisiana is very different from that in say Washington State. However, there is a crucial difference between the U.S. and the EU. Within the U.S., the mobility of capital and labor helps different states adjust to asymmetric shocks. So for example, if an economic shock such a collapse in oil prices hurts Louisiana but helps Washington State, unemployed capital and labor will migrate from Louisiana to Washington State. Within the EU, however, the mobility of labor in particular is still limited by inflexible labor markets. National differences in language and culture, when coupled with higher unionization and national policies that make it difficult to hire and fire employees, all make it difficult for labor to move from low employment to high employment regions. The result may be the persistence of high unemployment in regions of the Euro-zone that have responded unfavorably to economic shocks. This could have adverse political and economic consequences and conceivably fracture the EU. One way of dealing with such divergent effects within the Euro-zone might be for the EU to engage in fiscal transfers, taking money from prosperous regions and pumping it into depressed regions. Such a move, however, would by itself open a political can of worms. It is difficult, for example, seeing the citizens of Germany forgoing their "fair share" of EU funds in order to create jobs for underemployed Portuguese workers. Reflecting on these issues, several critics believe that the euro puts the economic cart before the political horse. In their view, a single currency should follow, not precede, political union. They argue that the Euro will unleash enormous pressures for tax harmonization and fiscal transfers from the center, both policies that cannot be pursued without the appropriate political structure. The most apocalyptic vision that flows from these negative views is that far from stimulating economic growth, as its advocates claim, the Euro will lead to lower economic growth and higher inflation within Europe. To quote one critic: Imposing a single exchange rate and an inflexible exchange rate on countries that are characterized by different economic shocks, inflexible wages, low labor mobility and separate national fiscal systems without significant cross-boarder fiscal transfers will raise the overall level of cyclical unemployment among EMU members. The shift from national monetary policies dominated by the(German) Bundesbank within the European Monetary System to a European Central Bank governed by majority voting with a politically determined exchange rate policy will almost certainly raise the average future rate of inflation. Q6. What then, do you think that the future holds for the success of the euro and the EU? I personally believe that the EU will make the euro work. Quite frankly, there is too much at stake here for the euro to collapse. I think that the ECB is a well designed institution that has a good chance as any of managing European monetary policy in a responsible manner, and in staying relatively isolated from short term political pressures. I do think that the wide disparity between the various economies of the euro-zone creates a potential structural problem, but my guess is that labor and capital will prove to be more mobile than most critics expect, and that over time the EU will find a way to deal with long standing unemployment in certain areas. I also believe that there is a good chance that Britain, Denmark, Sweden and Greece will join the euro-zone before 2002. The government of British Prime Minister Tony Blair is certainly signaling that Britain should join the Euro, and I think doing so is clearly in the bests interests of London's financial markets. Right now, London has a legitimate claim to being the financial capital of the EU. To hold onto this position, the British need to adopt the Euro, and I think ultimately they will do so. The Swedes are also signaling that they may join, and I believe that if they do the pressure on the Danes to join will be impossible to resist. As for the Greeks, their economy is now on track to meet the criteria required for euro-membership by 2002. Q7. Finally, what does a successful euro mean for the global economy? I think that if the euro is ultimately successful, it will be of tremendous benefit to the world economy. Successful implementation of the Euro should result in significant economic benefits flowing to countries within the Euro zone. For all of the reasons outlines above, successful implementation of the euro should boost aggregate demand within the EU, lead to an increase in the productivity of European enterprises, lower the cost of capital within the EU, and improve the efficiency of resource allocation, and particularly capital resources. The upshot should be significantly greater economic growth within the EU than would otherwise be the case. Moreover, if the ECB is successful in maintaining its independence from political influences and manages monetary policy in a judicious manner, this growth could be achieved without having to pay the price of high inflation. The world economy will obviously benefit from such a development. A successful EU economy could become one of the economic engines of the global economy in the 21st century, in much the same way as the United States has been a primary engine of the world economy ever since World War II. A strong and prosperous EU will provide a large market in which foreign companies can sell their products - and obviously that will boost the economic growth rate if foreign countries. Moreover, strong EU companies should be a source of significant inward investment directed at countries in other parts of the world. Such investment should help to stimulate economic growth in those countries. All of this should help to promote greater global economic growth. Obviously there is no guarantee that this will happen. There are some rough waters that the EU and the ECB will have to navigate through in order to achieve such a happy outcome - but such an outcome is within the feasible set of possibilities.