Euro (What it's Good For)

Currency in Crisis

This month marks the 10th anniversary of the decision in which countries were going to be allowed to participate in European economic and monetary union, one of the greatest experiments in modern history. It offers a timely opportunity to review the euro’s impact, especially given the widespread talk about how the euro is challenging the US dollar for supremacy.

What is often overlooked in discussions about the euro is that at its core, it is essentially an economic solution to a fundamentally political issue: on what conditions could Europe accept a united Germany? Under EMU, Germany’s future would inextricably tied to Europe’s and through the uber-mark, recast as the euro, Germany’s economic prowess would be shared with the region. At a very basic level then, the euro has been successful insofar as it permitted the reunification of Germany and to some extent and increasingly, integrating central and Eastern Europe to the west as well.

On purely economic grounds, the impact of the euro is not nearly as obvious as many of the dollar detractors would have us believe. It is true that by some measures, such as the currency used for international bond offerings, the euro is significant, but in most respects the euro does not appear to be significantly larger than the sum of its parts (especially the Deutschmark, French franc and ECU). Nor does it appear that the advent of the euro has enhanced economic integration within the region or boosted the region’s relative position vis a vis the United States.

The ECB’s own work shows that economic convergence (cross-country synchronization) appears to have risen considerable in the late 1980s, prior to the Maastricht Treaty, and into the late 1990s. However, counter-intuitively, in the past ten years the pace has slowed.

In a speech delivered in late April, ECB President Trichet acknowledged that the advent of the euro has not arrested the decline in the pace of productivity gains in the region. Average hourly productivity rose 2.3% in the 1980s and 1.8% in the 1990s. Since 1998, productivity increases have slowed to an average 1.2% per annum. By contrast, Trichet noted that US productivity increases have generally accelerated in the last 27 years, with an average 2.1% pace seen since 1998.

Some euro-philes would point out that the number of people employed in the euro-zone has increased by 15 million since the birth of the euro compared with only 5 million in the previous 9 years. Unemployment in the region is at its lowest level since the early 1980s. Yet the slower productivity growth does not appear to be as much as reflection of more people working, but rather weakness in investment. It is not just labor productivity that has slowed, but total factor productivity growth has slowed too. The euro-zone invested an average of 2% of GDP in the 1995-2004 period on information and communication technology, while the US spent twice as much relative to its GDP.

Productivity is critical because it allows for rising living standards for a society as a whole rather than simple redistribution. Despite the gallons of ink spilled on writing eulogies of the US, the fact of the matter is that in terms of per capita income, the advent of the euro has not helped the euro-zone to close the gap with the US.

*Source: U.S. Bureau of Labor Statistics

Ironically, a few countries in Europe that opted not to participate in monetary union have performed relatively better than those who joined the club.

*Source: U.S. Bureau of Labor Statistics

Of course this is not intended to be a comprehensive review of the euro’s economic impact, but simply to look at several time series such as productivity and per capita income that are important metrics of the economic well-being and competitiveness of a country.

What about the euro itself? Contrary to what passes as conventional wisdom, there is simply no evidence from the most authoritative source, the IMF, which indicates central banks as a group have sold a single dollar. In fact, as of the end of last year (the most recent data available), they hold more dollars than ever before. The euro’s share of official reserves seems at best marginally more than the sum of the role of its components (the mark, franc and ECU) in the early 1990s, prior to the run-up to the EMU. Admittedly, some central banks, most notably China, do not report the composition of its reserves, but that simply illustrates the limitations of the data (though the vast majority of China’s reserves are still believed to be denominated in U.S. dollars).

In terms of turn-over in the foreign exchange market, last year’s BIS triennial survey found that the euro’s role is hardly bigger than the sum of its parts. Specifically in 1992, the German mark account for 39.6% of all FX trades (remember because there are two currencies in every trade the total percentage total is 200). In 2001, the euro’s share was 37.6% and in 2007 its share had slipped to 37.0%. In comparison, the US dollar was on one side of 82% of all FX trades in 1992 and 90.3% in 2001. Last year, its market share slipped to 86.3%. Over the same time, the Japanese yen share fell from 23.4% to 16.5%, while sterling’s share rose from 13.6% to 15%.

Lastly, the use of the euro as a invoicing and settlement currency appears largely confined to the region. Since oil and various other commodities are invoiced in US dollars, it may be easier to understand why more than half of the euro-zone’s imports are not invoiced in euros, but the euro’s limited use for exports outside of the Europe may be surprising for many observers. According to ECB data, less than half of the euro-zone’s exports to Europe outside the EU and its candidates are invoiced in euros. Less than a quarter of the euro-zone exports to Africa are invoiced in euros. Less than 6% of its exports to what the ECB refers to as the Asia 6 (Japan, India, South Korea, Malaysia, and Thailand) are invoiced in euros. In contrast, U.S. data suggests that 93% of its imports and 99% of its exports are invoiced in dollars.

In conclusion, it is not immediately clear that the euro has bolstered the region’s competitive position or that the euro’s role in the world economy is significantly larger than the sum of its parts. What at first may have seemed likely to be a temporary delay in entering may be turning into a new fissure in Europe, with the UK, Switzerland, Sweden, Denmark, not displaying strong enthusiasm of joining. And hopes in some quarters that economic and monetary union would lead to political union seem rather unrealistic in any meaningful time frame.