EMU Introduction May 5th, 1997
European Monetary Union
1997 is a critical year for EMU, as the economic performance in 1997 will determine which countries join EMU in January 1999. The financial markets still have not quite come to terms with all the details of EMU nor does it realize that this union is going to take place for politicial reasons despite the economic pros or cons. The degree of convergence occurring at this time in addition to the “fuge” factors from one-off taxes, gold sales and pension swaps, all suggest that a wide group of European nations will be on board from the very beginning. The events of last December strengthened this view, when the Germans clearly compromised on the stability pact despite French opposition. This confirms our view that the political commitment (“will”) remains strong and that if necessary, compromises will be reached in order to keep EMU on track.
There is little doubt that this move to a single currency will face numerous challenges and obstacles over the next 18 months and the financial market will most likely witness an overall rise in volatility as we move closer to 1999. It should also be clearly understood that as the governments of Europe attempt to meet the criteria, subdued European economic growth and a sustained high level of unemployment is inevitable. In addition, the sheer cost to the corporate world of preparing to deal with EMU will undoubtedly reduce corporate profits and may begin to show up in corporate earnings particularly in 1998.
Franco-German relations still have problems to face namely the question of independence for the European Central Bank itself. The Germans want to ensure that the Bundesbank model prevails, which will mean tight monetary growth and the export of deflationary pressures to the balance of Europe. The French would like to see more political influence in monetary policy, which would introduce more flexibility than the Germans are perhaps willing to accept at this time.
Another critical issue at stake will be the number of countries who join from the very beginning. More recently, German officials have urged that some countries should not pursue political prestige thus creating a rush to join EMU. Instead, the Germans have suggested that nations should delay joining until they are in a position to achieve sustainable convergence. This issue alone is likely to create political divisions within Europe and fuel both debate as well as volatility over the coming 18 months. Furthermore, the fewer the number of nations who are able to join EMU in 1999, the higher the probability of a steeper economic decline for Europe as a whole. The emphasis will be to meet the criteria at all costs thereby placed the economic growth and unemplyment issues on the back burner. The fewer the number of EMU nations in 1999, the more likely that the entire experiment could fail by 2002.
The financial markets are also ignoring the factors of transition, which threaten the entire global economy – not just Europe. As central banks become mere branch offices of the European Central Bank, collective reserves will need to be consolidated and cross-European currency holdings eliminated. This means that there will become only one main reserve currency for Europe – the dollar. Corporations will increasing be forced into US dollars during the transition period due to the fact that investors will not be willing to gamble on the conversion rate to a Euro in the future. Since you cannot issue a 5 year corporate bond in Euros, increasingly we are starting to see a convergence within the private sector toward dollars and less deustchemarks.
The transition over the next 5 years will in the very least prespent on of the greatest periods of volatility in the century. The politicial will may be here to create EMU at any cost, but the resources and the preparation are seriously lacking. Vital details have been intentionally pushed aside leaving the nasty and unpopular items for the aftermath. In all, the only benefactor will be volatility, which is always created whenever uncertainty exists.
Martin A. Armstrong
Chairman Princeton Economics International, Ltd.
© Princeton Economic Institute