Comments on 'Europe and the Dollar' by David WightmanAuthor(s): John BradleySource: Irish Studies in International Affairs, Vol. 4 (1993), pp. 43-46Published by: Royal Irish AcademyStable URL: http://www.jstor.org/stable/30001807 .

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Comments on 'Europe and the Dollar' by David Wightman*

John Bradley

The Economic and Social Research Institute, Dublin

It gives me great pleasure to congratulate Professor Wightman on the excellence of his paper and on the depth of economic, political and historical insight he has brought fo bear on issues that are at the centre of economic debate between the United States and Europe (particularly the EC member states) and of vital concern to the wider world of Eastern Europe, Asia and beyond.

Paul Krugman, in his ominously titled book The age ofdiminished expectations, says that there are three kinds of writing in economics: "Greek letter', 'up-and- down', and 'airport'.' 'Greek letter' writing-formal, theoretical, mathematical- is how professors often communicate, full of 'equations, charts and graphs of stunning obscurity.' 'Up-and-down' economics is the economics of daily newspapers and television: inflation is up, the Dow-Jones is down, the dollar is up, but output is down, etc., all carried out against a background of flickering Reuter screens. 'Airport' is the language of economics best-sellers, full of apocalyptic predictions of booms and busts, of great depressions or boundless optimism, designed for the busy traveller to take his mind off airline accident statistics.

What is there, asks Paul Krugman, for the intelligent reader who wants to be well informed but doesn't want to study for a Ph.D. in economics? There is a fourth type of economics writing, which is deep, precise, relevant and exciting, of which Professor Wightman, John Kenneth Galbraith and Paul Krugman provide excellent examples. I wish there were more like them, and fewer 'Greek letter', 'up-and- down' and 'airport'!

Turning to Professor Wightman's paper, I take from it the following broad themes:

1. Paul Krugman, The age of diminished expectations, Cambridge, Massachusetts: The MIT Press, 1990.

*Presented at the Fourteenth Annual Conference of the Irish National Committee for the Study of International Affairs, 19-20 November 1992.

Irish Studies in International Affairs, Vol. 4 (1993)

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(1) The collapse of the post-war international monetary order, the Bretton Woods agreements, was brought on by the decline of American hegemonic power, exacerbated by weaknesses in the US economy.

(2) Although the Bretton Woods system made the birth of the EC possible in the mid-1950s, both academic and political opinion now in the US is critical of EC movement towards a single currency and Economic and Monetary Union (EMU).

(3) Conflicts between the fiscal and monetary authorities (in countries where the latter have an independent voice) have deepened recessions rather than attenuated them. Witness the US after the OPEC-II oil crisis, and Germany after unification. Professor Wightman's motoring analogy makes the point in a particularly striking way: Chancellor Kohl pressing on the accelerator while the Bundesbank simultaneously pressed on the break!

(4) The advantages claimed in the 1960s for freely floating currencies by such as Milton Friedman, namely easier international balance of payments, lower reserve requirements, no need for exchange controls, greater policy autonomy, were found in the 1980s to be dominated by the destabilising influences of international speculative capital flows in an age of electronic money markets.

(5) There is a need to create a new version of the Bretton Woods system in order to prevent (or at least restrict) the destabilising powers of the private financial sector.

In my comments of Professor Wightman's paper I wish to develop these themes, in particular the nature of US objections to European EMU. In effect, this makes a mirror image of the paper' s title, turning it from Europe and the dollar, into The US and the ECU (European Currency Unit).

American views on European EMU do indeed seem on balance to be less than enthusiastic. The US case against EMU was trenchantly presented recently by Martin Feldstein, a former chairman of the President's Council of Economic Advisers, in an article in the Economist last June.2 Drawing on US experience with the North American Free Trade Agreement, he argues that, just as nobody seriously suggests that the US, Canada and Mexico should form a currency union, neither should the European Community regard EMU as a prerequisite for completing the internal market (1992). Rather, he asserts, EMU is sought by some Europeans as a symbol of super-nationhood and an effective way to shift decisions on monetary and, eventually, fiscal policy from national capitals to Brussels. This is the political justification for EMU and, indeed, is one not acceptable to all EC members (i.e. the British and the Danes).

There are three aspects to the political case for EMU:

(a) EMU brings with it an independent European Central Bank (of sorts), with a mandate to resist inflationary monetary policies.

2. Martin Feldstein, 'Europe' s Monetary Union: the case against EMU', The Economist, 13 June, 1992. A reply, by four eminent European economists (Paul De Grauwe, Daniel Gros, Alfred Steinherr and Niels Thygesen) concentrated mainly on economic points and ignored the political aspects of Feldstein's article ('In reply to Feldstein', The Economist, 4 July, 1992).

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(b) EMU will dilute the hegemony of the Deutschmark and the rule of the Bundesbank, something that would be desired by other EC members.

(c) EMU would be the strongest possible signal that the EC is on its way to becoming a single state.

Turning now to economic considerations, a shift to a single EC currency would preclude exchange rate devaluations to offset regional competitiveness losses or a fall in regional demand. Rather, adjustment would have to take place through lower regional wages and prices, i.e. changes in the real rather than the nominal regional exchange rate. In the US the fiscal transfer system (i.e., social welfare and other income supports) provides a source of great regional stability, making regional monetary policy less important (i.e. each state does not need its own separate currency). Furthermore, the high mobility of labour in the US (e.g. from the northern 'rust belt' to the southern 'sun belt') assists in bringing about adjustment to regional shocks. Neither factor is present in the European Community nor in the rest of Europe: almost all taxes are paid to national governments and there are no automatic fiscal transfers from the EC as a whole to countries experiencing cyclical decline; and labour is relatively immobile.3

To summarise, Feldstein claims that, after EMU, EC governments will have to decide on whether to accept the greater volatility of employment and incomes that is a consequence of abandoning an independent monetary policy and flexible exchange rates, or accept the inevitable consequences: the loss of national sovereignty over taxes and public spending that would accompany the formation of a European federal state.

Feldstein's American perspective on this issue is refreshing in its directness:

I can understand that there are those who are willing to accept adverse economic effects in order to achieve a federal political union that they favour for other non- economic reasons. What I cannot understand are those who advocate monetary union but reject any movement towards a federalist political structure for Europe. That is a formula for economic costs without any of the supposed political benefits.

Another aspect of the dollar-ECU debate concerns the probable emergence on the world financial scene of a European asset that is at least rival to the dollar, if not dominant. In his 1990 Geary lecture at my own institute, the ESRI, Rudiger Dornbusch, another eminent American economist and adviser to President-Elect Clinton, contended that the costs to the US of losing monetary hegemony are likely to be small, since US institutions do not have an exclusive franchise on doing dollar- denominated business. Furthermore, the US dollar-denominated liabilities today are interest bearing and the gains from their issue are insignificant. In addition, he held that there was little need for any major international currency proposal to

3. Ironically, Ireland is the exception that proves the rule. Current and capital transfers from the EC, although small in comparison with internal Irish transfers, are not negligible, and Irish labour is highly mobile, particularly to the British labour market. Feldstein's critics (De Grauwe et al, op. cit.), contend that America needs a strong federal tax authority because differing regional tax rates can be evaded through migration. Europe has less need for a central tax authority precisely because labour mobility is low, and so national fiscal policies have more effect. Once again, Ireland is an exception!

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replace exchange rate flexibility. However, there were likely to be some costs to be borne by the US. The world

demand for US currency and dollar bank balances would decline; a higher risk premium may come to be charged on dollar-denominated assets; and financial liberalisation may increase the scope for the growth of Europe-located financial institutions. As to the desirability of a new Bretton Woods, Dornbusch is sceptical, since this would require close coordination of monetary policy between the European Central Bank and the US Federal Reserve, with the risk of locking the US into a level of competitiveness that is incompatible with growth. The alternative of managed flexible rates is preferred, with a full employment goal. Unfortunately for the aims and aspirations of EMU, these also are precisely the British objections to membership of the Exchange Rate Mechanism (ERM), but they only became widely-and acrimoniously-known after sterling's ignominious departure from the ERM!

What of the future of US and European economic relations? The omens are not good, although better news may break even yet. Krugman looks at three scenarios: 'happy ending', 'hard landing', and 'drift'. The first, depending on an acceleration of productivity growth in the US, would work to solve many of the economic problems plaguing the American economy (the budget deficit, the trade deficit, the growth of corporate debt). The second, involving a failure of the incoming Clinton administration to deal with these problems, is a serious possibility, and would accelerate US decline and, given the huge size of the US economy, bring with it greater world political and economic instability.

However, Krugman plumps for 'drift', where tomorrow is very much like today, with no radical improvement or deterioration. If the EC can overcome its present difficulties with Maastricht, an increasingly unified Europe will have a larger GNP than America's, and Japan will be about 80% of the US level. In effect, the US will have sunk to the number three economic power in a world where military hegemony may be less relevant, albeit somewhat comforting.

The real danger in this situation is a nationalistic US reaction: a shift from 'star wars' to 'trade wars', in the words of the economist Gary Shilling. Krugman pre- dicts that, at least as far as trade goes, the world economy is likely to be less unified in the year 2000 than it is today. Let us hope that he is wrong, and that we can be proud that a Dane, Franz Andriessen, and an Irishman, Ray MacSharry, were key players associated with the dramatic moment when the danger of 'trade wars' passed and the world began to come to terms with the full consequences of the end of the Cold War.

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