Welcome to Euroland: Rough Going Ahead Jude Wanniski and David Gitlitz May 8, 1998

Nearly a week after the French-German row over leadership of the new European Central Bank (ECB), it is clear the dispute hints at the sort of fissures that could come to typify the common currency project. Thursday, Wim Duisenberg, the German-favored Dutch central banker tapped to serve as the ECB's first president, gave notice that the EMU's technocrat/politician split could be a long-running contest of wills. Duisenberg labeled as "slightly absurd" the reported agreement in Brussels for him to step aside after serving about half his eight-year term in favor of Frenchman Jean-Claude Trichet, indicating that if there were such a "deal," he was not party to it. "I have never said that I will serve only four to five years," Duisenberg told the EU parliament, pointedly not ruling out the possibility of serving a full term.

The widely-held conception that this is a contest between the German obsession with monetary rectitude and the French inclination for a more permissive stance largely misses the point. Trichet is regarded as no less an inflation "hawk" than Duisenberg. With no automatic mechanism to assign responsibility to "tighten" or "ease," whoever is in the driver's seat will have an obvious edge in tilting policy toward regional conditions. The Dutchman is so much a part of the Deutschemark currency bloc that his perspective will naturally incline in that direction. There is every likelihood that it will make a policy difference, which is why German Chancellor Helmut Kohl was roasted by his parliament for indicating he had made the deal with Paris that Duisenberg now rejects. The market sees the EMU's vulnerability to political risk as leading to tight money in order to quell the concerns, which helps explain the rise of the principal European currencies since the EU summit, the D-mark rising to a near five-month high above 1.777$.

If there were a fixed reference point for the euro's exchange rate in terms of other commodities (i.e., gold), the not-so-subtle subtext of the socialist French government's complaint against Duisenberg would be irrelevant. With a neutral gold anchor, no central banker would have the latitude even to entertain consideration of the false choice between economic growth and protection of the currency's purchasing power. Currency union members would have to remove the real obstacles to growth in their tax and regulatory structures, or lose jobs and capital to more competitive environs.

But the totally discretionary policy apparatus being developed invites political pressure for action that can only complicate the ECB's assigned task of maintaining price stability. As long as there are only small fluctuations of the euro's gold price, there will be definite economic gains throughout the currency regime that flow from the efficiencies of a common currency. If there are disturbances that cause greater amplitudes in the euro gold price, the effects in each of the eleven nations will be more evident. Those countries that have steeper tax progressions will be squeezed more than those with shallower progressions, with capital and labor flowing from the former to the latter. When this occurred in the United States in the 1970s, there were major migrations from states with high tax progressions to those with no income tax, but there was little culture shock. The kind of tension we see in the debate over Duisenberg reminds us there will be culture shock and political frictions at the grass roots with relatively small fluctuations in the euro/gold price. There is no hint of what guidelines will be followed, and the word "gold" is never heard, except from those who argue the central banks should see their gold reserves. Duisenberg is said to favor an inflation-targeting approach, but he has been disinclined to establish a zone-wide target to which the bank could be held.

If all eleven countries were to adopt the same tax code, the floating euro would have much less regional variation and cause less political strain even with wide fluctuations. The euro's architects have a neo-Keynesian bent, and were never taught that tax progressions inhibit growth, especially when there is always risk of inflation. Note that Finland would be least effected by euro swings, Germany and France among those effected most. In addition, the socialist government of French Prime Minister Lionel Jospin remains committed to shortening the workweek from 40 to 35 hours with no cut in wages. This is a product of the fallacious zero-sum premise that fewer hours per employee will allow available work to be "shared" by more workers, reducing unemployment. In reality, it will increase unit labor costs and encourage capital to find friendlier locations, raising unemployment.

To add a bit more perspective, consider two scenarios, the best and the worst we can imagine. In the best, the euro managers would at least steer by the gold reference point. As Robert Mundell pointed out in his recent series in The Wall Street Journal, a successful launch would require a slow initial withdrawal of liquidity from the system because the euro would be more efficient "money." (Perhaps ten euros could do the work of eleven separate liquid units, which means one has to be withdrawn.) The excess liquidity would show up as a rise in the euro/gold price, and the French would have to accept a tightening to prevent inflation. If there are no exogenous shocks to the system, those countries such as France that wish to improve their relative position in wealth creation would have to lower their tax or regulatory barriers as well as their welfare incentives to remain on the dole. Over time, there would be a convergence toward similar tax and regulatory structures and very little cultural tension.

The worst case would involve a shock, such as any convulsions resulting from the Y2K phenomenon, when the computers click in on January 1, 2000. If there are wide swings in the euro gold price, the chaos might tear the system apart. Because we are only now beginning to understand the potential for Y2K chaos, we cannot evaluate probabilities the way Morgan Grenfeirs Ed Yardeni is now predicting a 60% chance of recession in the United States. If as we get closer to the date the euro architects face the prospect of currency explosion, they might like our idea of fixing the euro to gold as a way of substituting that anchor for the computer power that now manages currency chaos.