The Assumption of the Euro

Milan, 2 December 1999
Centro Congressi Cariplo

The euro promises to be one of the most important monetary developments in the last half century. It introduces a new force in the international monetary system. Upon its arrival it became the second most important currency in the world. From 1915 until the end of the century the dollar had been unchallenged as the dominant currency. Over the next decades, however, the euro will vie with the dollar as an alternative international monetary asset and share the seigniorage and power once allocated exclusively to the dollar. For the next few years tri-polar arrangements will characterize the dominant force in the international monetary system and the two independent exchange rates among them will be the most watched economic data in the business world.
The successful launch of the euro was initially greeted with worries that the euro would appreciate against the dollar, exacerbating competitiveness and unemployment problems in Europe. Instead, predictable liquidity factors led to a depreciation of the euro by more than 15 per cent. This downward movement, however, was, at least initially, associated with market expectation that the future course of the euro would be up. Hence euroland interest rates have been substantially below US rates. However, the recent slide of the euro toward parity with the dollar contains with it the risk that the euro will overshoot in a downward direction, not only introducing into the pipeline future inflationary risks, but changing the market view that the euro will recover and leading to a rise in interest rates.
What should the European Central Bank do? Its over-riding mandate is to preserve price stability. But monetary policy works with a lag. Correct policy requires forecasting inflation which depends partly on exchange rates. It would be therefore a risky course for the ECB to ignore the falling euro and its impact on the price of oil and other commodities storing up the potential for future inflation. The depreciation of the euro from its initial position of about $1.18 to near-parity with the dollar has gone far enough. Should the ECB intervene in the foreign exchange market?
There are two mythologies to be combated. One is that floating exchange rates will find an efficient equilibrium. The Plaza and Louvre Accords in the 1980s dispelled that false idea. The other is that daily turnover in foreign exchange markets swamps official transactions so that central bank intervention in the foreign exchange markets is futile, and that each time it has been attempted, the speculators have won. This is not factually true. For example, the Bank of Japan intervention in January 1988 reversed the downward slide of the dollar. Nevertheless, much intervention has been sporadic and useless because it neglects two over-arching principles.
The first is that the monetary effects of intervention should not be sterilized. Sales (unsterilized) of dollars by the ECB would automatically shrink bank reserves and set in motion automatic adjustment. Second, intervention to be effective must take place in both the spot and forward markets. If, for example, the ECB decided to intervene in the spot market to prevent the euro from dipping below par with the dollar, it should stand ready to sell spot dollars, and at the same time support the forward euro at a premium against the dollar equal to the one quarter of the interest differential between the dollar and euro 90-day bills.
In another context, I have recommended fixing the dollar-euro rate for a month before and after the turn of the millennium, to reduce unnecessary uncertainty in the even of massive computer breakdowns. It would be a convenient occasion for European and American cooperation on exchange rates at a time when it is not in the interest of either region to let the dollar-euro rate drop below parity. Persistent bearish expectations would risk lifting the entire pattern of European interest rates.
If the immediate danger point is overshooting of the euro in a downward direction, the longer-run danger is overshooting in an upward direction. The dollar moves pro-cyclically, and at the first signs of a US slowdown, the dollar will start to fall, the US current account deficit will appear a problem to be financed, and diversification into an appreciating euro will be inevitable. The problem would be exacerbated if the European recovery continues strongly. It should not be thought that upward movements in the euro generated by shifts in reserve asset positions would reflect the comparative needs of the two great economies.
Bear in mind the gyrations of the dollar-mark rate between 1975 and 1995 first the dollar fell in half against the mark, then it doubled against the mark, and then again fell in half. Similar swings in the dollar-euro rate would threaten to crack Euroland apart. The principle that the swings in the dollar-euro rate should be mitigated by cooperation between the Federal Reserve/Treasury and the ECB/ECOFIN should be established early in the history of the euro. In the future, preventing undue appreciation of the euro will become a problem, but today the precedent should be set in preventing undue appreciation of the dollar against the euro.
Taking into account also movements of the yen, it would be a good beginning to call into being a G-3 meeting for dealing with the immediate issue of eliminating damaging exchange rate instability arising from the not-so-far off Y2K problem. In the long run the opportunity to manage the international interdependence of the three most important currencies in the world and the central bank gold market should present an opening for the recreation of an international monetary system in the next century.