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EUROPEAN MONETARY UNION
TUESDAY, APRIL 28, 1998
U.S. House of Representatives,
Subcommittee on Domestic and
International Monetary Policy,
Committee on Banking and Financial Services,
Washington, DC.
The subcommittee met, pursuant to call, at 2:00 p.m., in room 2128, Rayburn House Office Building, Hon. Michael N. Castle, [chairman of the subcommittee], presiding.
Present: Chairman Castle; Representatives Paul, Manzullo, Hinchey, and Bentsen.
Chairman CASTLE. I apologize for being late, everybody. I was at the Capitol. We will try to move along as rapidly as possible. I will start with an opening statement which I have prepared here.
We have gathered here today to preview an historic event that to date has not been accorded the watershed status it probably deserves. This Saturday, May 2, 1998, eleven nations of Europe will agree to adopt a single currency to be known as the euro. These countries will become members of a European Monetary Union, set to begin next January. The implications of this action are nothing short of revolutionary, but by our standards, there has been remarkably little public debate.
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While it is not exactly comparable, think about the debate that would occur if we were here to discuss the possibility of the U.S., Canada, Mexico, and the countries of Central America joining together to use a single currency. That is what is about to happen in Europe.
The dream of a unified Europe that harkens back to the Holy Roman Empire may today be closer to reality than ever before. Incidentally, this first step will promote the integration of a competitive $6.4 trillion economy, second only to our own. This new currency could exert significant influence upon United States monetary, trade, and economic policies. Thus, it is important for this subcommittee to help Congress and the American people understand what the impact of the euro will be for the U.S. and the world.
The ambitious schedule to arrive at a common European currency appears to be on track, beginning with the first step of the 11 qualifying countries declaring their membership and fixing their respective exchange rates vis-a-vis the new euro. On January 1, 1999, the European Central Bank takes over monetary policy for the member states, and while national currencies continue to exist, stocks, government debt, bank accounts, and credit cards begin to be denominated in euros. On January 1, 2002, national currencies begin to be physically replaced by euros, and on July 1 of that year, national currencies will cease to exist.
European commercial and banking entities are expected to accelerate their consolidation to better compete with large global financial institutions such as those already formed in the United States and Japan. On the path to its economic integration, Europe will take dead aim on the greenback's position as the leading reserve currency in the world. Additional revolutionary changes are planned that are likely to permanently alter economic and political geography.
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Adopting a common currency at the same time as attempts are made to resolve the Year 2000 computer problems could lead to serious disruptions in European and world financial markets. Some, the Speaker among them, even fear that a general depression could result.
Multinational companies will need to devote substantial resources to prepare for the change over to the single currency on January 1, 1999. Early on, the Europeans will try to induce OPEC to price oil in euros. How the euro will compare to the U.S. dollar as a reserve currency and what effect a strong euro might have on the U.S. economy are questions begging answers. There is even speculation that the financial medium of choice for drug deals and money laundering may become 1,000 euro notes worth over $1,000 each.
The first step toward EMU occurred in 1990 and required the abolishment of capital controls between European Union member states. The second stage began in 1994 with the establishment of the European Monetary Institute. The third stage is to begin January 1, 1999 with the introduction of the euro and the fixing of exchange rates. The euro should make trading in Europe easier by moving Europe along the path of integration and moving for more stability in an international financial system.
Details about the mechanics of transition are eagerly awaited by the business community. Partly because of the euro, European businesses are streamlining suppliers and distributors as well as consolidating operations. They are also looking for new European markets for their products and services, since substantial transaction costs could be saved when one EMU country trades with another EMU country.
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Will the EMU be beneficial or detrimental to U.S. interests? This is the key question for us. Some have expressed concern that EMU could roil financial markets by drawing investment from the United States and compelling the U.S. Government to raise interest rates to attract that money back into the United States economy.
Milton Friedman has voiced concern that there will not be sufficient flexibility in wages and prices, mobility of workers, or an effective fiscal compensatory mechanism to take the place of the flexible exchange rates that will be lost. However, the main question for members is how will the euro affect the U.S. economy. Strong or weak, it will undoubtedly affect trade investment and interest rates. In our introduction to these issues, we will have a distinguished panel to guide us today.
Ms. Zanny Minton Beddoes is an Economic Correspondent for the Economist Magazine of London. Dr. Klaus Friedrich is General Manager and Chief Economist of the Dresdner Bank Group of Germany. Mr. C. Randall Henning is a Visiting Fellow at the Institute for International Economics. Ms. Jill Considine is President of the New York Clearing House. I hope I got the titles right and the names mostly pronounced correctly.
We appreciate all of you being here. I would like to see if any of my fellow Members wish to make an opening statement. We start with Mr. Bentsen before we go to the witnesses.
[The prepared statement of Hon. Michael N. Castle can be found on page 30 in the appendix.]
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Mr. BENTSEN. Thank you, Mr. Chairman. Mr. Chairman, I just want to commend you for calling these hearings. This is a fascinating subject which will either require great attention from the United States or could be a great academic experiment for us to watch, and very well could defy history, for what centuries Europe has been uncapable of doing in coming together, and now through the EMU, trying to create a monetary dynasty where political dynasties in the past have failed, so I appreciate you calling these hearings and I look forward to the panel.
Chairman CASTLE. Thank you, Mr. Bentsen.
Mr. Manzullo.
Mr. MANZULLO. I appreciate the opportunity. I am most interested in hearing your statements, or perhaps theories, as to how all the various countries have suddenly been able to meet with the convergence criteria, when just about a year ago the only country that met that was Luxemburg.
Chairman CASTLE. Thank you, Mr. Manzullo.
Dr. Paul.
Dr. PAUL. Thank you, Mr. Chairman. I have no statement but I would just like to thank you for calling these hearings. I think it is a very important issue and will prove to be of great value. Thank you.
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Chairman CASTLE. Thank you.
Now we will turn to our witnesses for their statements. We will start at my left and your right and work across. So we will go to you, Ms. Minton Beddoes.
STATEMENT OF ZANNY MINTON BEDDOES, ECONOMIC CORRESPONDENT, THE ECONOMIST
Ms. MINTON BEDDOES. Mr. Chairman and Members of the subcommittee, it is a great honor and a great pleasure for me to testify before you on the introduction of the euro. Thank you very much for inviting me.
In little more than eight months' time, on January 1, 1999, the European Monetary Union will be launched. The decision to launch a single currency is perhaps the boldest and riskiest——
Chairman CASTLE. Can you pull the microphone a little closer to you and maybe a little higher, too? You have to be close to them. I am sorry.
Ms. MINTON BEDDOES. The decision to launch a single currency is perhaps the boldest and riskiest move in the history of the European Union. It will be a powerful signal of European countries' determination to forge ever closer integration, both political and economic. This desire to promote an ever closer union is the most important reason for EMU.
There are also substantial economic benefits. Currency stability will bring efficiency gains. A single currency could enhance Europe's macroeconomic stability and it could prove a powerful force for promoting greater competition and flexibility in Europe's markets. However, the project also involves costs. Countries that pool their currencies give up the option of devaluation and forfeit an independent monetary policy.
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For EMU to be successful, Europe's countries must become sufficiently flexible to live with these structures. Eleven countries are likely to join EMU at the outset. They will create an economic unit close in size to that of the United States. In 1997 the GDP of the EMU area was about $6.3 trillion, compared with $8.1 trillion in the U.S.
Mr. Chairman, in my testimony today, I would like to give a brief overview of rewards and risks involved in the EMU project. But before I do so, I shall examine the background of EMU and give a short description of how the introduction of this new currency is likely to proceed.
Much has been written on all of these subjects and my summary will unavoidably omit important elements. For instance, I shall not discuss the international role of the euro, a very important issue, but one that will be addressed by other members of this panel. In my written testimony, I have attached a list of relevant books and articles that members might find interesting.
Opponents of EMU, of whom there are many, often argue that this project was forced onto Europe by Germany's Chancellor, Helmut Kohl, and France's former President, Francois Mitterrand at the Maastricht Summit in 1991. In fact, the history of European efforts to forge a single currency goes back far further. For instance, in the 19th century, France set up a Latin Monetary Union that embraced five other European countries. This monetary union did not last, but Europe did not give up the idea of permanently securing currency stability.
In the early years of postwar integration in the 1950's and 1960's, several proposals were made for creating a single currency.
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After the international system of fixed exchange rates fell apart in the early 1970's, Europe's desire for currency stability intensified. Europeans created a mechanism called the ''snake in the tunnel,'' through which their currencies would be tied to the deutschemark. This ''snake'' had many problems as Europe's countries joined and left more than once.
In 1978 Europeans tried a new tack. They created a formal exchange rate mechanism, the ERM, to limit currency fluctuations, but here too there were problems. Some countries, such as France, repeatedly devalued their currency.
Unhappy with the inadequacies of ERM and determined to foster ever greater economic integration, the European heads of government commissioned in June, 1988 yet another report on the creation of a single currency. This Delors Report formed the intellectual basis of a process that culminated in the Maastricht conference in 1991.
The Maastricht Treaty set a definite date for the launch of a single currency—1999. More importantly, it laid out in great detail the conditions a country would need to fulfill in order to be eligible for entry.
To be eligible for joining EMU, a country must have an independent central bank, its currency must have remained within the bands permitted by the ERM for at least two years, and most important, certain macroeconomic criteria must be met:
A country's inflation rate must have averaged no more than 1.5 percentage points that of the three countries with the lowest inflation rate.
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Its average long-term interest rate must be within 2 percent of the average interest rate of the three countries with the lowest inflation rate.
Its budget deficit must not exceed 3 percent of GDP.
And its ratio of government debt to GDP must not exceed 60 percent.
The idea behind these criteria was to keep EMU small by setting tough standards that at the beginning of the 1990's looked certain to keep out profligate Mediterranean countries, such as Italy, although both the fiscal criteria allowed some room for flexibility. But determined to join EMU at the outset, southern European countries have made genuine improvements in their public finances during the 1990's, while northern European countries struggled more than they expected to.
The aggregate budget deficit for EU countries fell from 6.1 percent of GDP in 1993 to 2.7 percent in 1997. This increase in fiscal discipline alone is an important achievement of the EMU project. But most countries in northern as well as southern Europe have resorted to various ''fudges'' to fulfill the 3 percent deficit criteria.
In a further attempt to promote fiscal prudence, the Maastricht Treaty set limits on euro member countries' future budget deficits. At the insistance of Germany, this part of the treaty was further stiffened in 1996 in the Stability and Growth Pact. This pact intends to limit EMU member countries' budget deficits and threatens any country that exceeds them, more than temporarily, with heavy fines.
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The final decision on which countries join the first wave of EMU will be made on May 2 at a meeting of the EU's heads of government in Brussels. Three members of the Union—Britain, Denmark and Sweden—have decided to opt out, for the moment at least.
Greece manifestly does not satisfy the conditions for entry, but barring some unforeseen shock, it is virtually certain that the 11 other members of the European Union will join EMU. To limit rumors of speculation, Europe's leaders would also fix their exchange rates with each other on May 2.
From January 1, 1999, monetary policy in the euro area will be determined by the new European Central Bank. This institution will be fully independent and charged with the goal of pursuing price stability. Decisions on monetary policy will be made by a governing council that is similar in structure to the Federal Open Market Committee, although rather more decentralized.
For three years, national coins and notes will remain in circulation, although technically they will be mere subdivisions of the euro. Actual euros will be introduced on January 1, 2002, and by July 1, 2002, national notes and coins will cease to be legal tender.
The economic benefits of the euro fall into three categories. The first is efficiency gains. The existence of a single currency removes the transaction caused in switching currencies. Firms no longer need to hedge against foreign exchange risk. Efficiency gains such as these are not negligible. The European Commission has estimated them at .5 percent of European GDP.
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The second benefit is greater macroeconomic stability. Several European countries have historically been prone to loose macroeconomic policies and high inflation. A single monetary policy from an independent central bank could provide these countries with an environment of price stability they might not have achieved alone.
The third advantage is a more integrated, vibrant market. The single currency may well foster greater competition, greater economic integration, as well as greater deregulation in Europe. European capital markets will quickly deepen and develop. Consumers will be easily able to compare prices across European countries. Many people even argue that the single market would be hard to maintain without a single currency.
But against these potential advantages must be set a number of risks and costs. The most important of these stem from the loss of monetary independence and exchange rate flexibility. Countries that join EMU will no longer be able to devalue their currency if their economies are hit by an outside shock, nor will they be able to set interest rates to suit their domestic purposes.
In evaluating these risks, it is useful to make the comparison with the United States, a country that has had a single currency for far, far longer. Just as Texas could not loosen monetary policy in response to the Texas oil shock, so individual countries with the EMU will be stuck with the EMU-wide interest rate, even if they suffer an economic downturn.
Economists usually point to three ways that countries or regions can make up for this loss of monetary flexibility: First, wages and prices must become more flexible. Second, labor must be mobile. And third, stabilizing fiscal transfers can offset these shocks.
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Compared with Europe, the United States has far greater labor flexibility and mobility. In Continental Europe labor markets are notoriously inflexible and European workers are much less mobile. Under a single currency, the costs of inflexibility could become much more acute, but the risks of labor immobility should not be exaggerated. Not only do Europeans not move between countries, they are also reluctant to move within countries, and yet European countries have maintained national currencies. One reason for this is fiscal transfers. Within many individual European countries, the level of fiscal transfers is very high. Within the European Union overall, it is very low. More worryingly, the fiscal provisions in the Maastricht Treaty limit the extent to which national governments can use fiscal policy.
Many economists argue that EMU will require either an extensive system of fiscal transfers between European countries or a recognition that the stability pact can be interpreted liberally.
Another risk is that the euro will make macroeconomic policy within Europe more, rather than less, volatile. This could occur in a number of ways. Despite its statutory independence, the European Central Bank could succumb to political pressure from member countries that wanted a looser monetary policy.
Policy coordination, particularly between EMU-wide monetary policy and national fiscal policies will not always be simple.
The Central Bank itself may have teething problems. The technical challenge of setting an appropriate monetary policy for a new currency is large and the risk of getting it wrong commensurately high. This risk is increased by the fact that Europe's economies are entering EMU at very different stages in their business cycle. An interest rate appropriate to Germany may well cause Ireland's economy to overheat. This lack of synchronization in Europe's business cycles causes some pessimists to suggest the euro risks a speculative attack.
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It is theoretically possible that speculators could attack future EMU members between now and January 1, 1999. Thereafter, even though separate notes and coins will still exist, it is hard to see how speculation would work. Only if there were any doubt about a country's commitment to EMU would speculation be possible, and that is unlikely.
In short, the risks of EMU are not risks of whether it will happen; they are risks about how well it will function and how well the member countries deal with the consequences.
In conclusion, Mr. Chairman, Europe is, to use a phrase from Peter Pan, embarking on an ''awfully big adventure.'' The European Monetary Union is not, as I have tried to illustrate, an idea that suddenly came from nowhere, but a goal many in Europe have long sought.
Finally, it is possible to be confident that the euro will indeed be launched, something that many doubted until recently. Much more difficult is the judgment of how well it will work. The introduction of the euro could be a catalyst for more flexible, dynamic, and prosperous economies in Europe. That would be good for Europe and good for the rest of the world. Thank you.
[The prepared statement of Zanny Minton Beddoes can be found on page 33 in the appendix.]
Chairman CASTLE. Thank you very much for a very good overview. You should be careful what you say, though, because next year we are going to embark on a 50-State quarter program, so we are going to have individual State quarters, so that it will all be the same quarters across the country, so you are absolutely right in what you say.
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Chairman CASTLE. We will go next to Dr. Friedrich.
STATEMENT OF DR. KLAUS FRIEDRICH, GENERAL MANAGER AND CHIEF ECONOMIST; DRESDNER BANK GROUP
Dr. FRIEDRICH. Thank you very much, Mr. Chairman. And thank you for your invitation. It is an honor to be here.
Next Sunday, Mr. Chairman, will mark the end of a six-year period, namely, since the signing off the Maastricht Treaty in February of 1992, of intense preparations for the euro. Come January 1, 1999, the euro will be a new currency, second only to the U.S. dollar in all-around importance as a domestic and an international currency. The euro will eventually represent, when everybody has joined, an economy of 370 million people, with a GDP slightly larger than that of the United States. And with the per-capita income of $22,000 per year, Europe will be the largest middle-class consumer market in the world.
The comparison of European trade and finance versus the U.S.A. reveals approximate equality in trade but not in finance, and there are two reasons for that. The first is European capital markets are relatively less developed than U.S. markets. Second, the U.S. dollar's use as transactions and reserve currency is far greater than such use of the sum of all European currencies today.
Today, European countries use the dollar, not only in their trade with countries such as Asia and Latin America, but even in trade among themselves. This will change over the coming years. Intra-European trade will become euro domestic trade next year. And in third country trade, the euro will gradually be seen as a useful alternative beside the dollar. Mideastern oil trade with Europe could be an early example here.
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From expanded use in trade would follow expanded presence of the euro in reserve stocks of central banks and of private holders. Another area where the euro will make an appearance is international wealth-holding and asset management. This is a huge market. If only 5 percent of privately held cross-border dollar assets were to be diversified into euros, this would amount to a shift of $1,000 billion in resources.
These are only the most important ones among a number of factors that lead, in my opinion, to expect a strong demand for that new currency. Of course, these expectations depend crucially on a set of prior conditions the euro must meet.
First, the euro must be introduced on time and without major market volatility.
Second, the introduction of the euro must not, by itself, become an inflationary event.
Third, the euro must be seen from the start as professionally managed by a central bank of first-rate quality.
I am confident on all three of those scores, despite considerable political complexities and despite a singular lack of enthusiasm for the new money, especially on the part of my own countrymen, the Germans. The euro agenda, as set down in the Maastricht Treaty has not missed a beat so far.
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This coming weekend will bring final decisions on EMU membership and exchange rates, which have long been expected and priced in by the markets. No surprises here. As far as inflation is concerned, which has been a particularly German worry, the remarkable global trend toward stable and even occasionally falling prices has been probably the single most salutary promoter of the European agenda.
Europe's average inflation rate today is 1.5 percent, with very little deviation from the average by individual countries. Even the German Bundesbank, which has been said to look for inflation under every stone, has publicly declared the euro as justifiable from a price stability point of view.
And, third, concerning the quality of the new European Central Bank, this is more an article of faith. The legal mandate of the ECB, set out in the Treaty of Maastricht, is fashioned after the German Bundesbank law, emphasizing political independence and uncompromising orientation toward price stability. Preparations are running at full speed in Frankfurt. Already there is some of that sense of esprit de corps in the European Monetary Institute that is so typical for best central banks in the world.
You will have noted, Mr. Chairman, I did not include structural issues such as high unemployment in my list of preconditions for a strong Europe. This is not to deny that unemployment is Europe's number one problem and that the very foundation of our social order will depend on how we will deal with this problem. But unemployment has crept up in Europe, and particularly in Germany, and the dollar has fallen or risen anyway.
In fact, while structural unemployment in Europe rose over the past ten years, the dollar weakened against the European Currency Union, the ECU, by about 40 percent. My point is that among all the many determinants of a currency's strength and weakness, unemployment seems to come fairly far down the line. Besides, most European economists today think that the peak of unemployment for Germany at almost 5 million, and for Europe at nearly 15 million, is behind us. There will be a slight decline in European unemployment because of the cyclical recovery to a GDP growth rate of about 3 percent going on in Europe right now. Further out, I expect the euro to exert precisely the kind of competitive pressure on our labor markets that we have so far not been able to bring about through structural reform.
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In the short term, I think the most notable effect of the euro will be in the financial markets. There is a revolution going on right now as financial intermediation between savers and investors no longer stops at national borders in Europe but focuses on this new Euroland. For the world outside Europe, this will bring about an alternative to the dollar, not as a substitute, but as a complement to the dollar.
The international financial system that is about to evolve would essentially be run by two equally dominant central banks, the United States Federal Reserve and the European Central Bank. The stability of that system will depend in no small measure on cooperation and coordination between those two institutions. While this is an enormous new challenge, as has been noted, there is every reason to expect that both will be up to the task. A stable system is, after all, the common interest of Europe and the United States.
Thank you very much, Mr. Chairman.
[The prepared statement of Dr. Klaus Friedrich can be found on page 45 in the appendix.]
Chairman CASTLE. Thank you, Dr. Friedrich, for your very interesting insights. We appreciate that.
Mr. Henning.
STATEMENT OF C. RANDALL HENNING, VISITING FELLOW, INSTITUTE FOR INTERNATIONAL ECONOMICS
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Mr. HENNING. Thank you very much, Mr. Chairman. I have an oral statement to make and would ask that the full written testimony be entered into the record.
Chairman CASTLE. Yes. I think you have all submitted statements, and all of those statements will be submitted as part of the record in addition to your oral statements.
Mr. HENNING. Thank you.
A monetary union in Europe will profoundly affect the external relations of the United States. It will pose serious challenges on both policy and institutional issues, ranging from the management of exchange rates to the organization of the International Monetary Fund.
To prevent potential problems from undermining transAtlantic relations, U.S. and European officials should consult proactively, with the oversight of the U.S. Congress, and for that reason, I applaud your holding these hearings today and appreciate your asking me to present my views.
In geopolitical terms, a successful Economic and Monetary Union—EMU—is in the interest of the United States. A monetary union will equip the European Union to extend economic and political stability to Central and Eastern Europe, a region in which the United States would otherwise be called upon to play a greater role.
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A successful monetary union will also benefit U.S. firms and citizens economically, through the reduction in transaction costs and consolidation of the European single market. But two caveats apply.
First, to be successful, the members of the monetary union will have to tackle a number of economic reforms, labor market reforms, deregulation, privatization, and further fiscal consolidation.
And, second, in the arena of international money and finance specifically, even a successful EMU will pose challenges to U.S. policymakers.
EMU will be the most far-reaching transformation of the international system in at least a generation. Assuming that the European Council decides this coming weekend to bring 11 member states into the monetary union, EMU will have a population significantly greater, a GDP only slightly smaller, and a share of world trade roughly the same as the United States.
If all 15 EU member states join, the GDP of the monetary union will be substantially larger than that of the United States.
The U.S.-EU trade and investment relationship will be the most important to the international economy. The United States and the monetary union, along with Japan, will have by far the largest trade and current account imbalances in the world. The exchange rate between the dollar and Europe's new currency, the ''euro,'' will be the single most important currency relationship in the international monetary system, and the euro will instantly become the second most important international currency, and for the first time in the postwar period, the U.S. dollar will confront a robust alternative.
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Well, let me elaborate on these general remarks by addressing four subtopics: the dollar-euro exchange rate; the future roles of the dollar and euro as international currencies; specific policy problems for the United States; and institutional questions that require attention.
The future exchange rate of the dollar and euro depends largely on decisions that are yet to be taken in the field of monetary and fiscal policy. Thus, these rates cannot be forecast with confidence at this time. Nonetheless, we can predict with greater certainty that the euro area will tend toward a policy of benign neglect of the exchange rate, because the openness of the monetary union, as measured by exports and imports as a percentage of GDP, will be considerably smaller than the openness of the individual member states. This will make the EU11 less vulnerable to, and thus more tolerant of, exchange rate fluctuations.
Partly for this reason, an increase in currency volatility is quite likely. Investors and portfolio managers will confront unusually high uncertainty during the transition to and early years of monetary union with regard to the speed of entry of those countries that are still outside the euro area; the future paths of monetary and fiscal policy; the supply of euro assets; and the development of the European capital market.
So market assessments of asset value will be relatively fickle, and as a consequence, the rebalancing of private investment portfolios from dollar to euro assets could be erratic rather than smooth, and even subject to temporary reversals, creating instability in the currency markets. This could be accompanied by sustained misalignment of the currencies that could contribute to a widening of U.S. and European trade and current account imbalances.
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Prudence counsels that governments and central banks take this prospect seriously. Greater volatility places a premium on their cooperating internationally, providing continuity and declaring their policy intentions in advance.
As the United States and euro area approach rough parity in economic size and weight in world trade, the euro will tend to displace the dollar as an international currency; that is, as a store of value, medium of exchange, and unit of account for private and official purposes.
The speed and extent of this displacement depends largely on the progress of the European Union toward liberalization and integration of its capital market, which determines the attractiveness of the euro for international investors. But this will require harmonization of tax, regulatory, and accounting standards within the euro area, among other things, and this will take time. So, I do not think that the euro will replace the dollar. At most, the euro might come to play a role that is equal to the dollar over time.
Private and official investors around the world will continue to accept dollar assets in quantities that will permit the United States to continue to run large current account deficits under normal circumstances. Again, though, two caveats apply.
First, the emergence of a more robust alternative to the dollar will make the international environment less forgiving of American policy mistakes, such as the over-expansionary monetary policy of the 1970's and the over-expansionary fiscal policy of the 1980's. American policy errors could cause substantially greater portfolio diversification out of dollar assets in the future than they did in the past. Although the future of the dollar remains mostly in the hands of American authorities, therefore, their range of policy options will narrow.
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Second, circumstances will not always be normal. We could envision some scenarios which are more serious. When private capital flows into the United States dry up in the future, as they did in 1987, for example, European authorities, less vulnerable to the appreciation of their currency, will have weaker incentives to buy dollars, and if they choose to do so, might insist on American policy adjustments as a quid pro quo. So American authorities are thus right to be calm, but should not be complacent about the introduction of the euro.
Now, monetary union will raise a number of specific policy questions for the United States that deserve more attention than they have received in the public discussion. It will create excess dollar reserves in the hands of European central banks that could eventually amount to something on the order of $50 to $100 billion. It will induce a rebalancing of private and investment portfolios from dollar to euro assets. Though this is hard to predict with precision, this rebalancing could eventually amount to $400 to $800 billion dollars. It will provoke greater exchange rate instability, as I have argued. EMU will have consequences for the international system arising from the relationship between the euro and the currencies of the member states that do not join the monetary union, the so-called ERM2 arrangement. And monetary union will divert the attention of European officials from global concerns to the successful completion of their project. So American and European monetary authorities should consult on these policy matters. Their ability to do so, however, will depend on addressing several institutional problems.
By way of concluding, I want to mention quickly three institutional questions that need to be addressed. First, the United States and the rest of the world have a strong interest in a European Union in which decisionmaking is transparent, institutional competence is clear and coordination occurs internally. But the institutional arrangements by which the external monetary policy of the euro area will be determined, however, fall short of this standard. The Maastricht Treaty leaves up in the air the question of how the EU is to negotiate international monetary agreements, who will represent the monetary union in international organizations, and who within the monetary union will be responsible for managing financial and currency crises.
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The European Central Bank, of course, will be involved in this, but the European Union must identify an official who can serve as the counterpart to the Secretary of the Treasury. They need to provide an answer to the question of whom should the Secretary telephone, or who should telephone the Secretary to resolve a crisis in the foreign exchange markets?
Second, the international institutions, such as the Group of Seven and the International Monetary Fund, will have to be reformed in light of the formation of the monetary union. While for financial regulation and fiscal matters, the Group of Seven finance ministers and central bank governors can still be an appropriate forum of decisionmaking, a ''monetary G–3'' should be created to discuss exchange rate and monetary matters among the United States, Japan, and monetary union, and the EU monetary representative from the political side should attend meetings of the monetary G–3 along with the president of the European Central Bank.
Finally, in the International Monetary Fund, European member states should also yield eventually to direct representation of the euro area. A consolidation of the quotas of the European member states into one would reduce the overall European share of IMF quotas, freeing up quota shares for other fast-growing regions of the world, which would contribute to better balance between economic size and influence within the organization. Consolidation would also rationalize the representation of Europe within the constituency system of the Executive Board.
Now, the European governments are reluctant to face these issues because they deal with politically sensitive matters of bureaucratic prerogatives. But the global economy may not permit the European Union to take its time in addressing these matters. Instability stemming from the formation of the monetary union itself, the continuing effects of the Asian financial crisis and a new currency or financial crisis, perhaps in the neighborhood of the EU, such as in Central or Eastern Europe, could require that emergency operations and international coordination be undertaken. The U.S. and European Union should have effectively operating institutional arrangements in place before, rather than after, the next crisis strikes.
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Thank you very much.
[The prepared statement of C. Randall Henning can be found on page 73 in the appendix.]
Chairman CASTLE. Thank you, Mr. Henning, for your insights. We appreciate that and look forward to having some question-and-answer with you in a minute.
And, finally, our clean-up hitter here today, Ms. Considine.
STATEMENT OF JILL M. CONSIDINE, PRESIDENT, NEW YORK CLEARING HOUSE
Ms. CONSIDINE. Chairman Castle, Members of the subcommittee, Congressman Hinchey, thank you for the opportunity to discuss with you the impact of the euro on the United States and Europe. As you know, in just a few short days, on May 2, European Union heads of government will decide at a summit whether the European Monetary Union should proceed.
When we consider the impact of EMU, it is important to appreciate that the euro is not just another currency that can automatically be supported by organizations that have installed multicurrency capabilities.
The EMU will replace existing currencies which do not use the same market conventions and will require the harmonization of things such as day-count basis—how many days will you be charging—interest rates, market holidays, coupon frequency and even reset dates.
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The implementation of these will require broad revisions to documentation and computer systems. However the Economic and Monetary Union in Europe effectively brings about a merger of capital markets of the countries that will join. It is not yet certain whether there will be strong demand from individuals or small businesses for euro-denominated financial products such as checks, credit cards, and electronic transfers before the euro bank notes and coins become available in late 2001 or early 2002.
However, major European corporations have indicated that they will be using the euro from its inception, and existing government securities in some countries will be redenominated into the euro. This implies significant change for all of banking and commerce. National and international payment and settlement systems will require major modifications. TARGET, the central bank payment system which will link all the countries of the ECB, will recognize only Christmas and New Year's as holidays on which it will not operate. Banking institutions will be legally required to make and accept payments in both the euro and in the home currency, and this is to both consumers and for trading partners.
Financial contracts will be converted into euros. Company accounts will be consolidated, audited, and reported in euros, and some organizations are also seeking to use the transition to euro accounting as an opportunity to change accounting conventions. Financial institutions that are subject to government regulations will be required now to report information in euros.
There are a myriad of books, articles, and writers and speakers who are a thousand times more qualified than I to comment on the euro, but the purpose of my comments today is to review the introduction of the euro from the point of view of its impact on payment systems and the transfer of funds between banking institutions.
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I would like to concentrate particularly on clearing and payment systems with particular emphasis on the New York Clearing House. I have been a banker, a former regulator, developer, user, and finally an operator of payment systems, and I think I may add a unique perspective. If we look at the New York Clearing House, it was founded over 145 years ago by 52 banks in New York City for the express purpose of promoting clearance and settlement. Today, our clearings daily average over $1.46 trillion. Add to this $1 trillion in Fedwire and over $700 billion on the securities side, you can see that the U.S. provides an extremely liquid payments arena.
CHIPS is by a wide margin the world's largest private sector large value payment system, and most of its members participate in other large value payment systems around the world. We move over $1.4 trillion daily, an amount that is greater than that on Fedwire and equal to approximately 20 percent of the amount moved on the G–10 funds transfer systems, and accounts for 95 percent of the U.S. dollar foreign exchange settlement.
We currently have 94 banks participating, representing 28 countries, with 70 percent of them non-U.S. banks. On an average day, we process over 225,000 transactions, but on a peak day, we are up to a half million, worth nearly $2.2 trillion.
The U.S. payment system was developed in response to the need of financial institutions around the world for safe, efficient and low cost ways to make payments in the world's reserve currency. The dollar continues to enjoy its primacy, in part because the mechanism for making dollar payments continues to be the most secure and efficient in the world. The dollar's size and standing goes hand in hand with the size and sophistication of the U.S. financial markets. Any payment system that handles large volumes must have access to liquidity in the currency that is being transferred. Thus, one reason why the largest dollar payment systems tend to be located in the United States is that the U.S. is the home to the deepest dollar credit markets and also where the dollars' lender of last resort is also to be found. For the same reason, yen payment systems tend to be located in Tokyo and the deutsche mark payment systems tend to be located in Frankfurt.
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In the new euro environment, however, there will be upward of 12 payment systems capable of providing for the clearance and settlement of the euro. Because there are 12 systems for one currency, it still reflects national borders and will probably be unlikely to attain the size of CHIPS or Fedwire, at least for a while. But there will also be increased competition, as well as opportunity for the global players.
A successful EMU could produce a number of important benefits for the new integrated market. The economic benefits include a more stable currency, lower inflation, and lower interest rates. Business efficiencies will result in significant cost savings and improved efficiency. The disappearance of intracountry exchange risk will be of key importance. New and greater business opportunities will come about due to easier product distribution and greater sales potential. Europe can become an easier and less expensive region for United States companies to sell their goods and services.
In creating what is essentially a one payment market, where before there were many, the euro will facilitate the emergence of pan-European banks. Banks such as Dresdner, Deutsche, or ABN/Amro, with strong franchises in home markets will be able to much more easily expand cross border. This might be compared to the recent changes permitting interstate branch banking in the United States, though on a much more significant scale and without the workarounds that the holding company structure permitted here.
This environment will incent multinational firms to consolidate their banking relationship with one cross-border provider, rather than the many, country-specific ones they now maintain. If they have not done so already, most firms are anxious to consolidate their own internal treasury functions. The opportunity is for well prepared banks to pick up new business and perhaps reduce cost through rationalization of the many accounts they hold in various institutions in various currencies throughout Europe, and also provides for better liquidity management.
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Banks, especially New York and U.S. banks, will benefit because they no longer need to specialize in individual European currencies in order to provide a broad range of services to customers who are located in these countries.
In the future, both corporate and bank payment systems will be designed to handle multiple currencies. With this system, it becomes convenient to shift payments from one currency to another. Put another way, there will no longer be a compelling need to make payments in U.S. dollars if cost, inconvenience, and uncertainty in dealing in dollars becomes too high. In these cases, banks and other parties making payments will have strong incentive to shift payments from dollars to other currencies.
The creation of the euro could potentially create an alternative to the role and status of the dollar as the world's reserve currency. However, many believe it is safe to assume that any change in the international role of the dollar will occur only gradually. As long as United States policies remain sound, there is no reason to believe that the euro will replace the dollar.
However, I do have some concern that certain economic sanctions which have broad secondary effects, not just on the target individuals, but on third-party financial institutions who have tangential contacts, such as the Iran-Libya Sanction Act, Helms-Burton and the Office of Financial Asset Control Regulations could be used as a competitive advantage against the United States and U.S. banks.
New York as a global financing center is a precious national resource to the United States. And when decisions are made as to which currency will be used for payment, people should not have to think about the U.S. political risk, be it implicit or explicit.
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But as we can see, as with any change, the introduction of the euro will offer both problems and opportunities; increased competition, consolidation, and the need to change versus the new efficiencies, new business opportunities, and improved financial control for both the public and the private sector.
Thank you for this opportunity and I will be happy to answer any questions.
[The prepared statement of Jill M. Considine can be found on page 86 in the appendix.]
Chairman CASTLE. Thank you, Ms. Considine, and thanks to all of you. I think we all have a much clearer picture of the euro situation than we did before we started, and we appreciate that.
What we will do is allow each member to ask questions for periods of five minutes. We may have two rounds of questions, but I hope you can hone in for a time point of view.
I will start. And I will tell you, Ms. Minton Beddoes, I found at least one European last night at a speech in New York City who is not entirely excited about the euro, nor is her country involved, and it was Lady Margaret Thatcher, whose opinions seemed to be fairly strong in this area.
How do you see the future of Great Britain with respect to the euro and what is the thinking of Great Britain with respect to the euro?
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Ms. MINTON BEDDOES. You probably spoke to the one person in Great Britain who does have indeed the strongest views on this issue. Britain has a political problem and several economic problems with EMU. The political problem is that it has become a huge party political issue, and the British public is more against EMU than many other countries in Europe. The last poll, I think, taken in 1997 that I heard of had a majority of two-to-one against. It is very much viewed by many British as being part of an inexorable creep toward a Federal Europe that they find deeply worrying.
Against that, however, the official current position of Britain is that the Chancellor, Gordon Brown, at the end of last year, made a statement where he did not rule out entry into EMU in principle but he said it would happen under five conditions that had to benefit Britain: It had to benefit the city; it had to benefit jobs; it had to benefit investment; Europeans had to have addressed the inflexibility of their labor markets; and the desynchronization of economic cycles between Britain and Continental Europe had to be sorted out.
That, in effect, basically ruled out European entry in the lifetime of this Parliament, which gets us to May 2002 at the latest.
The way I look at it is Britain does have three particular issues which affect us more than anybody else. First, we are further ahead in the business cycle; interest rates in Britain are higher.
Second, and partly as a result of the move toward EMU, the British pound has strengthened considerably against the other currencies. And if we went in at a current rate, there is a risk we would go in at an overvalued exchange rate.
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Third, the British economy is uniquely sensitive to interest rate movements in a way that other continental European economies are not, because a large majority of British homeowners have variable rate interest mortgages. Now, until that changes, any interest rate change affects us relatively more.
I think these are real issues. And the fourth issue is because opinion in Britain has been so against joining the European Monetary Union, British business is probably the least prepared, so there are practical considerations involved in early entry now. However, given all that, I would be very surprised if we did not join a successful EMU at some point. Thank you.
Chairman CASTLE. I will extend your comments to Lady Thatcher the next time I see her and see how she reacts to all of them. Thank you. We appreciate that.
Dr. Friedrich, Americans often tend to regard the EMU as primarily a political, rather than an economic enterprise; that is, EMU is viewed as being more about establishing a common European identity or solidifying Franco-German relations than about the economics of monetary union. Is this correct, in part or in full?
Dr. FRIEDRICH. I think definitely that the center or the centerpiece of this and the driving force is clearly political. I think it has to do with the vacuum in the east to Germany, when Russia, when the Soviet Union imploded and there was a political vacuum in the East and the Germans needed to be embraced by the other Europeans in order not to embark on a national oriented policy toward the East, for example. So this is intensely political. But we did set economic conditions and they have been met, more or less, and monetary—you know, monetary union in itself is of course a tremendous political agreement because other countries have given up their monetary sovereignty.
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Chairman CASTLE. Thank you.
Mr. Henning, based on sheer size alone, the new euro zone would appear to be a formidable force in international economics and finance. In this context, should EMU be welcomed by the United States or regarded with apprehension, and will EMU divert the attention of Europeans from important policy issues such as global trade, liberalization and NATO expansion in your view?
Mr. HENNING. My answer is that in broad terms, in geopolitical terms, EMU is clearly in the interest of the United States, for the reason that it will help the European Union provide greater economic and political stability to Central and Eastern Europe, and I think this has to be a compelling factor for U.S. policymakers.
The concerns that I raised in my presentation arise in the relatively narrow area of monetary and financial management. I think that each of these policy problems can be addressed. But they must be addressed in order to prevent them from developing into more serious problems or crises later. That is why I advocate a proactive approach.
Chairman CASTLE. Thank you, Mr. Henning. My time has elapsed for now, so let's go to Mr. Bentsen.
Mr. BENTSEN. Thank you, Mr. Chairman. A couple of questions.
I understand, if in fact this works, that the euro could become a reserve currency on parity with the dollar, but that is predicated upon sound fiscal and monetary policies that some would argue the United States maybe hasn't always had, but vis-a-vis other countries perhaps, it has looked better.
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What is to preclude this new euro thing, I guess the controlling board, the same as our open market committee or the individual members—while they have given up their national currency, they haven't necessarily given up their national fiscal policy. They made agreements that they will stay within a certain band of inflation rates and a certain band of deficit as a percentage of GDP. But who is to say that one country, when there is a disequilibrium, isn't going to, for political reasons if nothing else, if an election is coming up, say we are going to run an expansionary fiscal policy to pump up employment? There is no real way to control that, is there? And if that is the case, does that undercut the value of the euro?
Mr. HENNING. Is your question directed to one of us in particular?
Mr. BENTSEN. To anyone on the panel, I guess.
Dr. FRIEDRICH. Perhaps, Congressman, I will try, since I am the European at the table here. You said who is to say; nobody is to say. This is something we are going to have to find out. But there are certain things, like we have tightened up the Maastricht Treaty in the sense of we have set a limit on fiscal policies of countries, as opposed to going toward balanced budgets in Europe, and all 15 countries have signed that they will do so. I don't know how seriously one should take that. But in addition to that, look at the Italians, who used to be, you know, the odd men out on fiscal discipline; they have very much lower interest rates, and on the budget, they are benefiting from those low interest rates. In other words, sort of a self-fulfilling process here where you get rewarded for a sound fiscal policy. And I think that is in the system and we can only hope that this will—you know, that this will continue in the future. But nobody can sit here and assure you that a fiscal policy is going to be disciplined in Europe.
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Mr. HENNING. I agree with that. I think there are two possible sources of discipline. The first is the Stability and Growth Pact. The second is market discipline. If markets see governments going on a deficit spending spree, they can attach an interest rate penalty to the bonds that those governments issue.
Now, here too I am skeptical about the ability of the markets to be terribly discriminating, or at least discriminating fast enough to deliver a quick discipline. Nonetheless, I think that the two of these factors, the Stability and Growth Pact and market discipline will be stronger discipline than exists now.
Mr. BENTSEN. If I could ask two additional questions, one is a technical and the other is reversing the argument. Let's say this works, and maybe Dr. Henning can address this. Are we then, and I think Ms. Considine addressed it a little in her statement. If the euro starts to grow as a reserve currency, will we start to see, then, the effect of the well transfer that has occurred as a result of our account, the imbalance over the years through our trade deficits and all; can the United States expect the negative impact of trade deficits and imbalances that we have had since the 1980's?
And the second technical question, if you could answer, or maybe the Europeans could answer this, is how did you come up with the debt-to-GDP ratio of 60 percent; what is the basis for that?
Mr. HENNING. Well, on this question of the international role of the currency and the effect on the United States, it is true that right now the United States has a growing trade and current account deficit. It appears as if the European Union's current account surplus is growing. These two imbalances are both very large. I think it is quite plausible that with the euro in place, backed by a deep and liquid market for private investors, the consequences of the U.S. running a continuous current account deficit could be more severe in terms of the effect on the international role of the dollar.
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So, yes, I think we are likely to see more portfolio diversification out of dollar assets into euro assets in the future as a result of such patterns in the balance of payments.
Dr. FRIEDRICH. Congressman, on the 60 percent, that was going to take you back to 1990, when the Maastricht was fashioned. Then it looked like there was going to be an expectable nominal growth rate of GDP of 5 percent, 3 real, and 2 percent inflation. If you grow at that and run a budget deficit each year of 3 percent, then 60 percent debt level to GDP can be maintained. It is sort of a model calculation. Nobody accounted for low inflation, and this thing is now in trouble because nominal GDP growth is less than 5 percent and expected to be less than 5 percent, so it was sort of a little bit of an optimistic calculation. That is why some countries got in trouble with the formula.
Mr. BENTSEN. Thank you, Mr. Chairman.
Chairman CASTLE. Thank you, Mr. Bentsen.
Dr. Paul.
Dr. PAUL. Thank you, Mr. Chairman.
I would like to ask the panel if any of you know of any example in monetary history where a country or a group of countries have been able to establish a new fiat currency? Most currencies started, you know, as a weight of a metal. For instance, the dollar started as a Spanish mill dollar and it was the weight of silver; but to start a new currency, out of thin air, as a fiat currency—do we have an example of that in history?
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Dr. FRIEDRICH. I believe we have the United States as such an example.
Dr. PAUL. The United States?
Dr. FRIEDRICH. Yes.
Dr. PAUL. But the dollar was started as the weight of silver.
Dr. FRIEDRICH. Well, I think it certainly did become a fiat currency.
Dr. PAUL. It certainly is fiat. I am not talking about what it turns into, I am talking about starting. See, I don't know of any. All the currencies are fiat now. We really don't have a good example, from the best I can tell.
What would a definition of the currency unit be in the year 2002, after the other currencies are removed; will there be a definition of the currency unit?
Dr. FRIEDRICH. I am sorry; I don't quite understand the question.
Dr. PAUL. How do you define the monetary unit? I mean, we have to deal with reality. Does it have a value? Today you would define it as a weighted value with the various currencies; correct?
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Dr. FRIEDRICH. No, not the euro. This is a basket, that is the expression of the basket. The euro will be not a weighted average, but a genuine currency.
Dr. PAUL. Right; but there is no definition for it. I mean, we used to define a dollar as a weight of silver and a weight of gold.
Dr. FRIEDRICH. There is no such definition of the euro; not, for example in gold.
Dr. PAUL. Then we will have no definition. Is it true that the bank then will hold some gold?
Dr. FRIEDRICH. The Zencher Bank will hold some gold, yes; but not necessarily understood as backing, but simply a small part of the stock of foreign investors.
Dr. PAUL. Do we know if that will be 10 or 20 or 30 percent?
Dr. FRIEDRICH. We don't exactly know that yet; no.
Dr. PAUL. Do we know how each country contributes to that?
Dr. FRIEDRICH. There is a formula, but I don't think it is exactly—I don't think I could give you numbers now. The treaty says reserves are going to be turned over to the central bank in a certain proportion to GDP but the breakdown between foreign currency and gold is not clear.
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Dr. PAUL. Governments always maintain monopoly control over money—this is history—and when the kings did this, and it was a gold currency, they did this for power, so they could wage war and wage welfare programs. But then they diluted the matter; they clipped the coins to inflate the currency. The main purpose that governments have monopoly control of money is to monetize debt. Now I understand that under this situation of the new unit, you will not monetize any individual country's debt; is that correct?
Dr. FRIEDRICH. That is correct. It is explicitly forbidden in the Maastricht Treaty.
Dr. PAUL. Now that is very impressive, if it could work. I don't know how government is going to give up the prime reason for having the currency, and that is to monetize debt. And what happens, because there will be no control of debt, no matter what kind of rules there are. I mean, a country goes into a recession, they have welfare programs, tax revenues go down, there will be debt. And what happens if one country is in big trouble and the other is doing well? What is the central bank going to do?
Dr. FRIEDRICH. We have had the question in a sense before, and I think one of the answers is it is a market kind of solution there. The market will punish, through interest rates, a country that does not practice fiscal discipline. That is part of the answer.
Dr. PAUL. But you will have unified interest rates throughout Europe, won't you?
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Dr. FRIEDRICH. No, we will not. Only the policy rate of the central bank will be unified but not capital market prices, long-term rates.
Dr. PAUL. In a particular country, they would have to be charged higher interest rates?
Dr. FRIEDRICH. They can carry a risk premium; yes.
Ms. CONSIDINE. If I might add to that. If you think of it in terms of the United States, where there is a unified monetary policy but you may have different States and different municipalities issuing government debt and that would be carrying a different rate, I happen to think that because of this sort of difference in fiscal flexibility that may come about; that market discipline is probably going to become even more laser-like than we think because it is going to have to be the market that will have to come in and make some of these adjustments.
So going to your earlier point, you were saying I am not certain how fast the market will react. I happen to feel strongly the market is going to be reacting even more quickly in terms of market discipline in these instances.
Dr. PAUL. It will be interesting to see what happens when the deficits rise throughout Europe and find out what the central bank is going to do. If they are really going to reject the traditional role of monetizing debt, that will be very interesting to see.
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Chairman CASTLE. Thank you, Dr. Paul.
Mr. Hinchey.
Mr. HINCHEY. Thank you very much, Mr. Chairman. Thank you for the opportunity to participate in this hearing and for inviting this very distinguished panel to join us today.
I particularly want to welcome an old friend, Jill Considine, from New York, and express my appreciation for her great contributions to the State and the country, through a variety of positions both in the public and private sector in New York. I would also like to welcome Dr. Friedrich, with whom I had the opportunity to visit in Frankfurt at a recent financial conference. I listened to him very intently today and very much appreciated his remarks.
This is a remarkable situation. It seems that we are about to come upon the culmination of a process which began back in 1948, the vision of the unified Europe through the establishment of this unified currency. There will be some glitches along the way, I am certain, but I think as you all indicated, this is a very positive thing for Europe. I think it will also be very positive for the United States, although it will take us a while to get used to this new relationship once it gets started.
Ms. Considine mentioned some of the anomalies in American law, such as the Helms-Burton Act, and the difficulty that it might create. Could you expand on that a little bit, Jill?
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Ms. CONSIDINE. I know that there have been some instances in terms of the sanctions and the implications for some of the European and Asian institutions. And let me start out by saying that the Clearing House has worked a lot, and the banks have worked with OFAC and we have developed interdict software and actually the Clearing House becomes a channel for OFAC communications that go out. But it does raise the visibility of U.S. sanctions and it irritates some of our trading partners. You could very well have a Venezuelan making a transfer to Cuba, and it is in U.S. dollars. Now it is not prohibited in either Venezuela or Cuba; the dollar is the currency of settlement. The dollar would go through the United States, because of liquidity in the market, because that is where the settlement would occur, and that payment could be stopped or interdicted if you want.
There is the opportunity, the possibility, for dollar payment systems to develop offshore, and by having them offshore, they may not have the same risk management techniques there are with the dollar. It becomes then totally out of the control of the United States. And I think that it is very necessary for the U.S. at times to use these sanctions, but I think we need to think about using them with more of a rifle approach than the shotgun, so that it is aimed at those you want to be impacted, and not third parties who may be involved in the transaction.
Now with the United States in the past making up such a large percentage of the international trading, you could get away with that. I just think it is something we need to look at, just as institutions need to be competitive, I think we need to look in terms of the dollar and competition going forward. It is just sort of something to put on the radar screen for future times.
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Mr. HINCHEY. It has implications for our relationship with other countries around the world, not just Europe. Mr. Henning said a number of times that there will be a tendency on the part of a great many people to diversify their portfolios; and while the euro is not going to replace the dollar, it will in some sense displace it; as people who now hold dollars will hold dollars and euros. This shift has implications for the United States economy in that context. And I wonder if you could speculate exactly what those implications might be.
Mr. HENNING. Well, one might think a diversification from dollar assets to euro assets would lead to a depreciation of the dollar and an increase in U.S. interest rates; but it is not that simple, unfortunately, because this effect depends on a number of other things, including the supply of euro assets. You know, if the supply of euro assets rises to match the increase in demand for them, this switch-over theoretically could take place without any change in interest rates or exchange rates.
However, the likelihood that the rate of change of demand and supply of euro assets is going to be perfectly offsetting all the way through this process seems very low to me, which is why I say that with some degree of assurance that we are going to have an increase in the volatility of this exchange rate. So that, I think, is a pretty clear consequence. And with an increase in volatility, it is possible that we could get a sustained period of misalignments of currencies that could be detrimental to trading and current account balances.
Mr. HINCHEY. Thank you, Mr. Chairman.
Chairman CASTLE. Thank you, Mr. Hinchey.
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Let me try to ask some fairly fast questions. I will start with you, Ms. Considine.
What would the impacts be for the United States if the euro comes to challenge the dollar's role as the world's preeminent currency?
Ms. CONSIDINE. Well, I think we have talked about some of that previously. But I think one of the things that we want to look at is in terms of just almost the day-to-day life that we have. Currently, with oil and some of the commodities being priced in dollars, we don't go through any shock in terms of foreign exchange risk for anyone who is an American consumer. Now, if you had a shift so that oil was no longer being priced in the dollar and was being priced in the euro, and then we had a difference in the foreign exchange rate there, the day-to-day life for an American would then be tied up in what had happened to the foreign exchange rate and what we were paying for oil. When it is priced in dollars, it becomes totally transparent, and we have enjoyed many, many years of some of the world's commodities that have been priced in the dollar and never having to worry about the exchange rate.
I think the other thing that we might see is that the United States at times does have a certain degree of insularity, and that comes from having such a huge market, and we tend to look inward. We may see that as a counterpart in Europe when you have a market that now can be almost the size of the United States, you certainly don't need to look outside of your own borders. And if you started seeing, if you wanted to say, a weighted 40 percent, two huge currency blocks that are becoming very insular, I don't think that has very positive implications for world trade going forward.
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So I think both the United States and the euro zone need to be cautious about their insularity, especially as they grow bigger and have the opportunity to just look inwards.
Chairman CASTLE. Thank you.
Mr. Henning, what are the implications of EMU for banks and financial services? Will corporations increasingly rely on capital markets for their financing? And, if so, won't this lead to new consolidation in the financial services industry in Europe? And are U.S. financial service providers well positioned to gain market share in this new euro zone?
Mr. HENNING. Well, the answer to the first half of that question is, yes, certainly. The formation of the euro area will lead to or at least facilitate a further consolidation and integration of European banking and financial markets. I think it is in the interest of U.S. financial institutions to be competing in this area. I will defer the question as to whether or not they are well prepared to compete to a representative from the financial services industry.
It was once thought that having an international currency was important to international competitiveness in the banking sector. When the pound sterling was the dominant international currency, that was an advantage for British banks; when the U.S. dollar became the dominant international currency in the early part of the postwar period, that was an advantage for American banks.
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But financial markets and banking markets have evolved over the last several decades, so that there is an unbundling, if you will, of financial services. Now, the source of the loan can be separated from the currency denomination of the loan through swaps and other kinds of financial innovations. So it is not so important for American banking institutions to continue to have a predominant role for the U.S. dollar.
Chairman CASTLE. Thank you.
Dr. Friedrich, can an EMU entrant later decide to opt out of the monetary union? There was some discussion about that earlier, about previous formulations of this. Is there a risk one of the countries may opt out or be perceived as opting out by the market, being the financial volatility?
Dr. FRIEDRICH. There is no such perceived risk in the market right now and there is simply no provision in the treaty for opting out after joining. There is some opting out right now by Denmark and the U.K. from executing, basically, on the Maastricht Treaty—even though they have done that, they have fulfilled the criteria—that they are not going to join. That is opting out, but before the fact. After the fact, neither the market nor anybody I know of has any kind of concept of how that might be done.
Chairman CASTLE. Thank you. Let me ask one final question while I am on it. I have a hundred more questions here that we are not going to get to.
How seriously do you take the warnings of American academics like Martin Feldstein, who suggested that political and economic tensions created by the single currency could even lead to war? That is a pretty strong statement.
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Ms. MINTON BEDDOES. Mr. Chairman, Dr. Feldstein wrote a very provocative article. I find it very interesting, but I would not go as far as he would along that line.
However, I think he has taken to an extreme a very real question, which is: Is the introduction of the single currency conducive to or will it make more difficult the necessary process of structural reform in Europe's labor markets?
I am quite optimistic on this. I think the euro can be a powerful catalyst for a more flexible labor market in Europe, for greater deregulation and more prosperous European economies. However, I can see there is a danger that an alternative reaction might be to blame the euro for higher unemployment, given the structural impediments that some European economies have, and that in turn could create political problems between the countries within the EMU.
Second, there is, I think, the greater problem of the relationship between the countries within the countries of EMU and those in the European Union but not yet in EMU, and there I see a much greater prospect for political division. And as the countries such as Britain lose out relatively in terms of their influence in the European policymaking process, it is possible to see political divisions there. But in short, I think Dr. Feldstein was making a point by going to an extreme.
Chairman CASTLE. One thing we are not allowed to do is politics without implications.
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Dr. Paul.
Dr. PAUL. Thank you, Mr. Chairman.
Chairman CASTLE. That is not correct. We should go to Mr. Hinchey first.
But, Dr. Paul, go ahead. I am sorry.
Dr. PAUL. This question is for Mr. Henning and it has to do with the IMF. I am not a fan of the IMF, and your statement about the IMF is actually very encouraging to me because you say the European share of the IMF quotas will go down—which I see this as a greater burden on us, which is fine, because we are already objecting—and you say it probably frees up the quotas for these developing countries.
Well, we already have one-third of the countries, these currencies, that aren't usable anyway, so I think this is working to our benefit, those of us who are objecting to the way the IMF functions. So could you comment on that?
Mr. HENNING. Yes; I would like to elaborate on that. I abbreviated my earlier comments in the interest of time. There will not be an automatic consolidation of the European quota after the monetary union is formed. This would have to be the product of decisions in Europe and at the International Monetary Fund to consolidate the European quota. I am arguing that it is desirable to do so.
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The EU15, their collective shares of quotas in the IMF is almost 30 percent. But this is based on a calculation that includes intra-European trade and investment. If you establish a quota for the monetary union as a whole, you would have to exclude these intra-European flows from the calculation of the appropriate quota share. And when you do that, you come up with a number that looks a lot more like the U.S. quota share. This would have to be a decision by the European Union and the IMF. It would perhaps involve an amendment to the Articles of Agreement of the IMF to permit this.
Dr. PAUL. I think that would weaken the IMF, but I am not worried about that happening.
I have a question for Dr. Friedrich. I read recently, and how reliable it was I do not know, but it said 70 percent of the German people object to this union. Is that a correct figure?
Dr. FRIEDRICH. It is a correct figure.
Dr. PAUL. How do we reconcile that?
Dr. FRIEDRICH. Well, you know, Germans are very proud of the German mark, which celebrates its fiftieth birthday as we sit here, and it was a successful currency and they don't want to give it up. However, their democratically elected Congressmen have ratified the Maastricht Treaty just about unanimously, so we have a real gap here between the grass roots feeling and the political representation. And they have not only ratified Maastricht once, they have done it two or three times, a few days ago again. So is this a miscarriage of democracy? I will leave it up to you. I mean, you are probably more of an expert on it than I am.
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Dr. PAUL. It doesn't sound like democracy. Of course, if we run into a problem, if Europe runs into a problem, of course the tension is already there, and most of you admit that there is no guarantee that everything will be smooth sailing, so we are all at the top of a business cycle now. We are going to go into a recession, even though Germany and France have high rates of unemployment already. I mean, a serious recession will come. So I think about the time this hits, the worldwide recession will hit, and then this 70 percent who are already objecting to it, it makes me a little nervous about what might come from this.
Dr. FRIEDRICH. It makes me nervous too, because those are our customers and we are dealing in that new money and we are dealing with a public that is not all that enthusiastic about it, which makes our job rather hard.
Dr. PAUL. Is that 70 percent generalized for Europe?
Dr. FRIEDRICH. It is just Germany, and it is broken down. You can analyze it. It is that young people are more for it, older people are more against it. Highly educated people are more for it, less educated people tend to be against it. So you can break it down, but the overall number you have is quite correct.
Dr. PAUL. What would the percentage be in France?
Dr. FRIEDRICH. Just about 51 percent. They had a referendum and the euro won that referendum by the slightest of margins. I would say 51 percent in France are for the euro. It might have increased somewhat in recent months.
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Dr. PAUL. Thank you.
Chairman CASTLE. Thank you.
Mr. Hinchey.
Mr. HINCHEY. Thank you, Mr. Chairman. I wonder if our European friends on the panel would comment on the social implications, at least short term, of the establishment of the euro? The situation in Europe is quite different than it is in the United States. One could characterize it in a variety of ways. One might say that Europeans value their workers more than they are apparently valued here in the United States. For instance, European workers receive more vacations. These things are likely to change.
To what extent are they likely to change, what are the implications of those changes, how well will those changes be received, and what does that mean for the success of the euro?
Dr. FRIEDRICH. Well, Congressman, if I might, I would say it is interesting where you sit. I mean, in Europe, sometimes you have speakers talking about the Americanization of the European labor market, and usually those are opponents of the euro. And then one would say, well, what is so bad about Americanization of the labor market? It means competition, and we certainly have lacked competition. And here I am talking about the German labor market, and I think we have had social systems that also are basically based on the lack of competition.
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This will change. I think this is a good thing. I think it is a good thing to let some fresh air into our labor markets and to stop these overall contracts that go for whole industries and for whole regions, and allow a worker to be prepared on the basis of his productivity. There will be social change; people will have to take more responsibility for their own old age requirements. This is in the cards. The point is, we are going to have to do this anyway, euro or no euro.
Ms. MINTON BEDDOES. I would agree entirely with that. I think the social change that is necessary in Europe is necessary whether we have a single currency or not. It is necessary because of the pressures of globalization and the pressures that we all live in. However, I think it is a question as to whether the single European currency will promote this process or not. I hope it does. I can see a way through which it will do.
However, there are some indications recently that do worry me. France, I think, is the country that worries me most in this regard, and the French Government has been talking about introducing, for instance, 35-hour weeks, which are a movement in the opposite direction to the one that would make markets more flexible. So I cannot categorically say that I am sure Europe is going to deal with these challenges by making its markets more flexible.
As an Anglo-Saxon, as a Brit, we have gone far further toward the Americanization of our labor markets, and I can look at Continental Europe and see that it must be done either way, but I hope that the euro promotes this, rather than acts as a break on it.
Mr. HINCHEY. Thank you.
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There has been some discussion about the inevitable competition which will arise between the dollar and the euro that might give rise to other aspects of competition between the United States and the European community.
Jill, I think you used the phrase ''currency blocks,'' and the problem that might come about as a result of that. And Mr. Henning, in his statement, referred to the need for there to be someone with whom our Secretary of the Treasury ought to be able to communicate on a fairly regular basis. Someone whom he can phone, as you said, and have a conversation, so problems can be avoided.
How likely is that to happen? Is there any mechanism that is moving toward that objective and will there be, in fact, recognition of the necessity to keep that kind of communication going? The relationship between the United States and Europe is a very strong one in a number of ways. We should make certain, as this process goes forward, that things are done amicably, whatever differences arise—and there will inevitably be some—that those differences are settled amicably and there be venues for the settlement of those differences.
Dr. FRIEDRICH. Well, Congressman, I think the first telephone number that is now about to be in operation is the telephone number of the central bank in Frankfurt, and that will clearly speak for monetary policy in all of Europe. We have not had that before.
And Mr. Henning talked about volatility of the exchange rate. I think that is a very, very serious challenge for the new European Central Bank and the Federal Reserve to coordinate their economic policies. And here we do, in fact, have something quite important which we did not have up until this point, and that is a telephone number of the European Central Bank.
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Mr. HENNING. If I can address that, the European Central Bank has to be involved in this, of course, but the ECB cannot and should not do this job alone. The political side of the international monetary policymaking, which would correspond to the Treasury Department in the United States, is underdeveloped and its working relationship with the ECB is very ambiguous.
So what I think needs to be done is that the European Union should identify an official on the political side to speak for the euro area in the international negotiations, give this official a mandate to negotiate agreements, both formal and informal ones, agree in advance within the Council of Ministers to procedures for quickly ratifying or rejecting any agreement that this official negotiates with—say the Secretary of the Treasury—and move away from the unanimous decisionmaking to qualified majority voting within the Council.
Now, when I raise this question with Europeans, they sometimes tell me that it should be the presidency of the Council of Ministers to whom the Secretary of the Treasury should address his or her questions. The problem with that is that the presidency of the Council of Ministers will be held from time to time by countries that are not in the monetary union, which is the case right now. So that is obviously an undesirable solution and more needs to be done.
Chairman CASTLE. Thank you, Mr. Hinchey, and I would like to thank the panel. This brings to a conclusion our hearing.
I have a quote here that somebody handed me from Jean-Pierre Chevenement, I guess you pronounce it, the French Interior Minister, who recently talked, in quotes, talking about the EMU, said that, ''The sea is calm, the dining room is great, the orchestra is playing. When we see the iceberg, it may be too late.''
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I hope we don't have another Titanic in the next century with respect to monetary policy, and I think your appearing here today gives us in America some added confidence that the right decisions have been made, and perhaps just knowledge about what is really happening with respect to the euro. It really has not gotten, until recently, much attention at all; and even recently, there has been sort of a spate of articles that have not had a lot of depth or the normal coverage one might get for some of the other problems we seem to have in Washington, DC. And I think it is of vital importance, and we really appreciate you being here and taking the time to answer our questions. We thank you and with that we stand adjourned.
[Whereupon, at 3:50 p.m., the hearing was adjourned.]
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